1 DAVID M. FURBUSH (SBN 83447; [email protected]) DHAIVAT H. SHAH (SBN 196382; [email protected]) 2 O’MELVENY & MYERS LLP 2765 Sand Hill Road 3 Menlo Park, CA 94025 Telephone: (650) 473-2600 4 Facsimile: (650) 473-2601 5 Attorneys for Defendants Ellen M. Hancock, R. Marshall Case, Dick Stoltz, 6 Herbert A. Dollahite, Adam W. Wegner, Beverly Brown, Sam S. Mohamad, and William Yeack 7
8 UNITED STATES DISTRICT COURT 9 NORTHERN DISTRICT OF CALIFORNIA 10 11 In re Master File No. C-01-2661-MMC
12 EXODUS COMMUNICATIONS, INC. SECURITIES LITIGATION 13 REQUEST FOR JUDICIAL NOTICE IN SUPPORT OF DEFENDANTS’ 14 This Document Relates To: MOTION FOR CERTIFICATION
15 ALL ACTIONS Hon. Maxine M. Chesney 16 Hearing Date: Not Set 17
18
19 20 21 Pursuant to Federal Rule of Evidence 201, defendants Ellen M. Hancock, R. Marshall 22 Case, Dick Stoltz, Herbert A. Dollahite, Adam Wegner, Sam S. Mohamed, William Yeack, and 23 Beverly Brown respectfully request that this court take judicial notice of each of the following 24 documents, true and correct copies of which are attached as Exhibits A through C hereto: 25 A. In re Stac Electronics Securities Litigation, Second Amended Consolidated Class 26 Action Complaint For Violation Of The Federal Securities Laws, Master File No. 92-1120- 27 R(BTM), filed November 18, 1993. A true and correct copy of that complaint is hereto attached 28 as Exhibit A.
REQUEST FOR JUDICIAL NOTICE MASTER FILE NO. C-01-2661-MMC
1 B. In re Daou Systems, Inc. Securities Litigation, Third Amended Class Action 2 Complaint For Violation Of The Federal Securities Laws, Master File No. 98cv1537-L(CGA), 3 filed May 16, 2002. A true and correct copy of that complaint is hereto attached as Exhibit B. 4 C. In re Portal Software, Inc. Securities Litigation, Master File No. C-03-5138-VRW, 5 Consolidated Third Amended Complaint, filed May 19, 2005. A true and correct copy of that 6 complaint is hereto attached as Exhibit C. 7 These complaints are proper subjects for judicial notice because they have been duly filed 8 in the Ninth Circuit and in the United States District Court of the Northern District of California, 9 and they are part of the court record in those proceedings. See Grimes v. Pinn Bros. Constr. Co., 10 No. C-01-2787 EDL, 2002 WL 356521, at *2 (N.D. Cal. Feb. 26, 2002) (“It is proper for a court 11 to take judicial notice of the contents in court files in other lawsuits.”) (citing Mullis v. U.S. Bank, 12 Ct., 828 F.2d 1385, 1388 n.9 (9th Cir. 1987)).
13 Respectfully submitted,
14 DAVID M. FURBUSH DHAIVAT H. SHAH 15 O’MELVENY & MYERS LLP
16
17 Dated: October 12, 2005 By: /s/ David M. Furbush David M. Furbush 18 Attorneys for Individual Defendants 19 Ellen M. Hancock, R. Marshall Case, Dick Stoltz, Herbert A. Dollahite, Adam W. Wegner, Beverly 20 Brown, Sam S. Mohamad, and William Yeack
21 MP1:969048.1 22 23 24 25 26 27 28 -2- REQUEST FOR JUDICIAL NOTICE MASTER FILE NO. C-01-2661-MMC
EXHIBIT A 1 WILLIAM S . LERACH (68581) LEONARD B . SIMON (58310) 2 THEODORE J . PINTAR (131372) MILBERG WEISS BERSHAD 3 HYNES & LERAC H 600 West Broadway, .Suite 1800_' 4 San Diego, CA 92101 Telephone : 619/231-1058 d 5 JOSEPH H . WEIS S KEVIN J . YOURMAN (1W7159) 6 DAVID C . KATZ LAW OFFICES OF JOSEPH H . LAW OFFICES OF JOSEPH H . WEIS S 7 WEISS 1800 Avenue of the Stars 319 Fifth Avenue Suite 100 0 8 New York, NY 10016 Los Angeles, CA 90067 Telephone : 212/532-417 1 Telephone : 310/277-157 4 9 - and -
10 Co-Lead Counsel for Plaintiffs
11 UNITED STATES DISTRICT COURT 12 SOUTHERN DISTRICT OF CALIFORNI A
13 TIMOTHY J . ANDERSON, NEIL SINGER ) Master File No . and ARTHUR SINGER, on Behalf of ) 92-1120-R(BTM) 14 Themselves and All Others Similarly ) Situated, ) CLASS ACTIO N 15 Plaintiffs , 16 vs .
17 GARY W . CLOW, DOUGLAS L . WHITING, ROBERT W . JOHNSON ; . ARTHUR J . 18 COLLMEYER, JOHN R . WITZEL, ROBERT A . HOFF, CROSSPOINT VENTURE 19 PARTNERS, LAWRENCE G . FINCH, SIGMA MANAGEMENT, SIGMA MANAGEMENT II, 20 L .P ., SIGMA PARTNERS, RUSSELL J . SECOND AMENDED CONSOLIDATED ROBELEN, IDANTA PARTNERS, STAC CLASS ACTION COMPLAINT FOR 21 ELECTRONICS, ALEX . BROWN & SONS, VIOLATION OF THE FEDERAL INC . and MONTGOMERY SECURITIES , SECURITIES LAW S 22 Defendants . 23
24 In re STAC ELECTRONICS SECURITIES 25 LITIGATION
2 6 Plaintiffs Demand A This Document Relates To : Trial By Jury 27 ALL ACTIONS . 21 I Plaintiffs, by their undersigned attorneys, for their
2 Complaint against defendants, allege upon information and belief
3 except ¶1[20-21 which are alleged upon personal knowledge, as
4 follows :
5 NATURE OF THE ACTION
6 1 . This is a class action on behalf of all purchasers of the
7 stock of Stac Electronics ('"Stac" or the "Company") between May 7,
8 1992 and July 20, 1992 . Stac manufactures data compression
9 products that increase the effective capacity of storage device s
10 and are used by . owners of personal computers that use Microsoft
11 Corporation's MS-DOS or comparable operating systems . Stac's
12 "Stacker" software products provide an increase in the data storage
13 capacity of personal computers for much less cost than purchasing
14 additional "hard disk" storage capacity . By 1990, millions of
15 personal computers using the MS-DOS or comparable operating systems
16 existed and appeared to provide a large potential market for Stac's
17 Stacker products . Because Stac was first to market with a data
18 compression software product, during 1991, sales of Stac's Stacker
19 products exploded as users of personal computers found those
20 products an inexpensive and effective way to increase the data
21 storage capacity of the MS-DOS operating systems of their
22 computers . This allowed Stac to achieve significant growth in its
23 net income, as well as earnings per share through December 31,
24 1991 .
25 2 . By late 1991, 90% of Stac's revenues and over 90% of its
26 profits came from the sale of its Stacker 2 .0 data compression
27 product . Because the then currently available versions of
28 Microsoft's MS-DOS operating system did not have data compression
- 1 - 1 capability, the sale of Stacker 2 .0 to owners of personal computers
2 using the MS-DOS operating system and purchasers of new computers
3 which came with the MS-DOS operating systems was the main market
4 for Stac's Stacker 2 .0 product . However, Stac's business would-be
5 severely injured if Microsoft included data compression capability
6 in its MS-DOS operating system (which Microsoft periodically
7 updated), as computer owners using the MS-DOS, system could then
8 obtain data compression capability at no extra cost by obtaining
9 the upgraded MS-DOS operating system and purchasers of, new persona l
10 computers supplied with the MS-DOS operating system would obtain
11 that capability with the purchase of their computer and have no
12 need to purchase separate software providing such capability .
13 3 . As a result of the niche Stac had found in the personal
14 computer software market, its revenue and net income exploded in
15 the latter part of calendar 1991 and early 1992 . However, Stac's
16 top executives knew by late 1991 that Stac's competitive position
17 was being impaired and that its strong growth in revenues and
18 earnings would shortly come to an end because of the increased
-19 availability and popularity of competitive compression data
20 products and because (as they had learned) Microsoft intended to
21 include data compression capabilities in its next version of its
22 MS-DOS operating system, which it was then currently developing and
23 intended to release as soon as possible in 1992, and that this data
24 compression capability would be included at no additional cost in
25 Microsoft's upgraded MS-DOS system . This presented a terrible
26 threat to Stac and its insiders . Thus, they decided to undertake
27 a public offering of stock of the corporation, part of which was to
28 be sold by the corporation and part of which was to be sold by
- 2 - 1 insider and controlling stockholders in an effort to raise capital
2 for the corporation to help it service the upcoming downturn in its
3 business and allow the insiders to cash out of their illiquid Stac
4 stock before these adverse facts became public knowledge, which
5 they knew would destroy the value of their stock before they were
6 able to complete a public offering .
7 4 . However, by late 1991 and continuing up to the date of
8 Stac's initial public offering on May 7, 1992 (the "Offering") , the
9 market and demand for Stac's products changed and Stac's insider s
10 and controlling shareholders realized that Stac's profitable growth
11 had peaked and that Stac would soon suffer declining revenues, net
12 income and earnings per share . By the date of the public offering,
13 Stac's insiders knew, but the public did not, that two very adverse
14 facts existed that were negatively affecting Stac's business .
15 First, demand for Stac's most important data compression product
16 (Stacker 2 .0) had weakened due to the introduction of a new popular
17 competitive product and due to customer resistance to purchasing
18 separate data compression software products'in anticipation of the
19 availability of upgraded personal computer operating systems that
20 included data compression capacity . Stac's insiders and control-
21 ling shareholders knew, but the public did not, that this situation
22 would worsen as Stac's data compression algorithm was not truly
23 proprietary ; nor was it adequately protected . by patents, meaning
24 other companies could quickly and cheaply create competitive
25 products . Second, Stac's insiders and controlling shareholders
26 knew, but the public did not, that Microsoft Corporation, the
27 software giant on whose MS-DOS operating system Stac compression
28 data products were dependent, had decided to include data
- 3 - 1 compression capabilities in its next upgraded version of its MS-DOS
2 operating system, which Microsoft was then developing and which it
3 intended to announce and introduce as soon as possible in 1992 .
4 Stac's insiders and controlling shareholders knew these adverse
5 facts meant that the results of operations of Stac's business had
6 peaked and were beginning to decline and that Stac would not be
7 able to continue to achieve the kind of revenue and income gains in
8 the future that it had enjoyed in the recent past .
9 5 . Upon learning of Microsoft's decision to include
10 compression data capability in its next upgraded MS-DOS operating
11 system software, Stac's insiders knew that any announcement of
12 Microsoft's decision would make the public offering they were
13 contemplating impossible to achieve . Therefore, to delay such an
14 announcement by Microsoft and to permit them to complete the public
15 offering before this adverse information became public, Stac's
16 insiders commenced a negotiation with Microsoft for Stac to license
17 to Microsoft Stac's data compression technology, so that Microsoft
18 could utilize that technology to create the data compression
19 capability in its improved MS-DOS operating system . Although Stac
20 realized that to license its technology to Microsoft for such
21 purposes would also have a negative impact on its revenue growth
22 and future profitability, as it would reduce,the market for Stac's
23 data compression products, it nevertheless pursued these negoti-
24 ations because it never intended to reach an agreement with
25 Microsoft ; but rather, only to tie Microsoft up in negotiations for
26 a long enough time to permit Stac to pull off its public offering
27 prior to Microsoft announcing its decision to include data
28 compression capability in its next upgrade of its MS-DOS operating
- 4 - 1 system . Thus, during late 1991 through April-May 1992, Stac's .top
2 officers engaged in negotiations with Microsoft, during which
3 negotiations Microsoft repeatedly confirmed to them that it was
4 actively negotiating with other data compression software vendors
5 to purchase or license their technology while also working on
6 creating its own data compression capability and that regardless of
7 how the negotiations with Stac turned out, Microsoft had made the
8 decision to include data compression capability in its next
9 upgraded version of its MS-DOS operating system, which would be
10 released as soon as possible in 1992 .
11 6 . In addition to attempting to delay any announcement of
12 Microsoft's decision to include data compression capability in its
13 upgraded MS-DOS operating system, Stac's insiders also undertook
14 action to artificially inf late Stac's reported results for the last
15 period (ending March 31, 1992) that would appear in the Prospectus,
16 so as to make it appear that Stac was continuing to enjoy strong
17 demand for its data compression products and achieving strong
18 growth in revenues and profits, thus concealing that demand for its
19 most important product .had, in fact, weakened . This was achieved
20 by Stac offering certain of its customers special terms' beyond
21 those it normally extended to induce them to order extra amounts of
22 Stac's data compression products prior to March 31, 1992, including
23 special price discounts and unlimited and/or expanded rights of
24 return if the products were not resold . These activities were note
25 the normal "channel fill" which customarily follows the intro-
26 duction of a new product, but rather, extraordinary and unusual
27 efforts to boost the sales of a product, demand for which was
28 softening . By so doing, Stac improperly recorded revenues and
- 5 - 1 understated its required reserves thus materially overstating its
2 net income and earnings per share for the period ended March 31,
3 1992 . Because Stac had by these actions "borrowed" large amounts
4 of sales from future periods, Stac's insiders knew this virtually
5 guaranteed that Stac's financial results following March 31, 1992,
6 would decline sharply from those reported for the March 31, 1992
7 period and in fact, by the time of the public offering Stac sales
8 were already softening, . in part because customers were already
9 returning product purchased on-special incentive terms . prior t o
10 March 31, 1992, or refusing to order additional products, as they
11 did not need any . In addition, by so doing, Stac's insiders
12 exposed the corporation to substantial liability under its secret
13 and undisclosed price protection obligation to its distributors,
14 further insuring that Stac's future financial results would decline
15 sharply after March 31, 1992 . -
16 7 . Realizing that these negative trends were already
17 adversely affecting, and would soon overwhelm, Stac's business,
18 Stac's insiders and controlling shareholders decided to undertake
19 a large public offering of Stac stock so that the Company and its
20 controlling shareholders could obtain millions of dollars by
21 selling Stac stock to public investors before the adverse condi-
22 tions overtaking Stac's business could no longer be concealed and
23 . would become publicly known, which would make any such stock sale
24 . impossible . In order to achieve their goal, defendants issued a
25 series of false and misleading statements in Stac's Prospectus for
26 the Offering and on the multi-city "Road Show" undertaken to help
27 sell the stock in that offering, as well as in securities analysts'
28 reports, press releases and other public statements issued there-
6 - 1 after to support and inflate the stock in the aftermarket . In
2 these statements , defendants presented Stac's business in a very
3 favorable light, without making any disclosure that, in fact, its
4 business had peaked and was entering a period of adversity which
5 would be characterized by declining revenues and falling profits
6 due to the adverse factors affecting its business that are detailed
7 herein .
8 8 . During the Road Show presentations, Stac and its under-
9 writers stated the Company was enjoying strong demand for its
10 Stacker 2 .0 product and that Stac expected to achieve increased
11 revenues in net income in the quarters following its March 31, 1992
12 quarter , forecasting earnings per share of $ .55 and $ . 82 in fiscal
13 1992 and 1993, respectively .
14 9 . The May 7, 1992 Prospectus presented Stac as a company
15 that had recently reached profitability and was, enjoying great
16 success and strong growth -- reporting the following :
17 Statement of Operations Data Six Months 18 Fiscal Year Ended Ended September 30, March 31 , 19 1987 1988 1989 1990 1991 1991 1992
20 Revenues $625 $749 $ 755 $1 , 762 $8 , 390 $2 , 333 $17,057
21 operating income ( loss ) 47 (112 ) ( 502) (1 , 055) 133 ( 1,0333) 8,084 22 Net incom e 23 (loss ) 33 (58 ) ( 477) (948 ) 195 (983) 5,074
24 Net income (loss) per 25 share - ( . 01) ( .03 ) ( . 05) .01 ( . 04) .21
26 The Prospectus represented that Stac ' s " revenues increased in each 27 of the last six quarters ," that "the quarterly increases in 28
- 7 - 1 revenues have been due primarily to increased demand for Stacker
2 products 11 and that the " increases in revenues in the second
3 quarter of fiscal 1992 resulted partially from awards and reviews
4 published in the quarter ." The Prospectus gave no indication that
5 defendants knew that such growth would not continue, that Stac's
6 orders had already begun to weaken by the date of the public
7 offering and that Stac's profitability would decline sharply in
8 coming months, stating only that Stac's net income would
9 . " fluctuate i' in the future .
10 10 . Stac's May 7, 1992 Prospectus stated the Company's LZS
11 technology used " proprietary algorithms ," its data compression
12 products .were "for personal computers that use Microsoft Corpora-
13 tion's-MS-DOS or compatible operating systems ." The Prospectus
14 represented that Stac's " discounting activities have [notl
15 significantly affected revenues or results of operations in any
16 given period ," " price competition has not been a major factor for
17 the Company's Products ," and that the " Company believes that it
18 provides adequate allowances for returns ." Finally, the Prospectus
19 represented that the purpose of the stock offering was " to increase
20 the Company's equity capital ," and to provide funds to " increase ,"
21 i .e ., for " expansion of Litsl sales, marketing and support
22 organization ," as well as " facilities expansion . "
23 11 . The Prospectus contained a listing of certain "risks" of
24 purchasing Stac stock, including that vendors of personal computer
25 operating systems " could seek to expand their product offerings by
26 designing and selling products using data compression technology, "
27
28 i Here , as elsewhere, emphasis has been added unless otherwise noted .
- 8 - 1 that there was "no assurance Microsoft . will not incorporate
2 a competitive data compression technology in their products ," "no
3 assurance that the Company will sustain its recent rate of revenue
4 growth ," and that it anticipated quarterly " fluctuations "Z in net
5 income in the future .
6 12 . Two underwriting firms co-managed Stac's May 7, 1992
7 stock offering . As they had agreed with Stac and its insiders the y
8 would do, as soon as they could after the "quiet period" following
9 the offering had expired, these firms issued very positive research
10 reports on Stac, which strongly recommended purchase of the stock ,
1 1 while forecasting strong earnings growth in fiscal 1992, 1993 and
- ~f 12 1994 to $ .55, $ .82 and $1 .15 per share, respectively . These
13 analysts' reports were based on information provided by Stac an d
14 its top officers, which reviewed and approved the reports, thu s
15 adopting them as their own . In addition to forecasting increasin g
16 earnings for Stac through fiscal 1994, the analysts' reports stated
17 that Stac was "the leading developer of data compression softwar e
18 for personal computers ," was the " best-poised company to exploit
19 the data compression market's opportunities ," and was " Well-
2 0 positioned to take advantage of this market onnortunitv ." The
21 analysts' reports also stated Stac had the " dominant position i n
22 the underpenetrated and ranidly growing market for data compression
23 products ," that would " enable . it to emerge as one of the leading
24 players in the computer software industry " and "the critical
25 resources . necessary to sustain its recent success ," even if
26 additional competitors entered its markets .
27
28 2 Webster's New World Dictionary defines "fluctuate" as "to vary irregularly" or "to rise and fall like waves ; undulate . "
- 9 - 1 13 . In early July 1992, when another personal computer
2 software company announced disappointing financial results and its
3 and other software company stocks (including Stac's stock)
4 declined, Stac's top executives and representatives of its
5 underwriters quickly reassured the markets there were " no corporate
6 developments " at Stac to account for the decline, there were no
7 problems with Stac's business, that its Stacker 2 .0 product
8 " continues to fly off the shelves ," and that while overall economic
9 softness would result in Stac achieving less revenue growth tha n
10, earlier forecast, this . was not due to- problems specific to Stac or
11 its products, and was not due to any " channel-stuffing " activity
12 prior to or during Stac's strong March 31, 1992 quarter --
13 representing that the strong sales growth it achieved in that
14 quarter was due to " glowing press reviews " . of its Stacker 2 .0
15 product .
16 14 . These statements were all false and misleading when made .
17 Stac's products were not adequately protected by patents or truly
18 proprietary algorithms . At the time of the Offering, Stac's
19 business had peaked and begun to decline which Stac's insiders knew
20 would result in Stac suffering declining revenues and falling net
21 . income . At the time of the . Offering, demand for Stac's main
22 products was already weakening and Stac was encountering problems
23 in selling those products, in part due to the introduction of a new
24 and very successful competitive data compression product -- thus
25 Stac was no longer the leading company in the data compression
26 software business . In addition, Stac knew that Microsoft had
27 decided to introduce an enhanced version of its MS-DOS operating
28 system which would for the first time include its own data
- 10 - 1 compression capability ("DoubleSpace") which would greatly injure
2 the market for Stac's main products . To conceal the softening
3 demand for its products by March 31, 1992, Stac's insiders artifi-
4 ciaily inflated its sales and net income for that period by getting
5 certain customers to take shipments of products by offering them
6 special incentive terms, including price discounts and expanded .
7 rights of return, beyond those it extended in the ordinary course
8 of business, thus "borrowing" sales from future periods and
9 ensuring Stac's 'results from operations following the March 31 ,
10 1992 quarter would decline . Also, these artifices resulted in
11 Stac's reserves for returns of product being inadequate . In
12 addition, the offering was not undertaken to increase Stac's equity
13 capital or provide funds to expand Stac's business or increase its
14 sales and marketing operations, but rather, to get cash to buffer
15 the Company from the impending decline in its business and to
16 enable Stac's insiders to cash out some of their Stac stock before
17 its business collapsed .
18 15 . As a result of these false and misleading statements and
19 artifices, on may 7, 1992 Stac and certain „of its insiders and
20 controlling shareholders sold three million shares of Stac stock to
21 the public at $12 per share in the offering, obtaining $36 million,
22 and thereafter pushed the stock price to a high of $15-3/4 per
23 share in early June 1992, in part, by issuing securities analysts'
24 reports which falsely presented the current condition of Stac's
25 business, Stac's competitive position and presented widely
26 exaggerated forecasts of increased profitability in fiscal 1992,
27 1993 and 1994 . But, on July 20, 1992, less than three months after
28 the Offering, Stac revealed that its sales for its third quarter
- 11 - 1 ended June 30, 1992 -- the quarter in which the public offering
2 took place -- had fallen by almost 20% from the March 31, 1992
3 quarter, and that its net income had fallen by 34% -- and that Stac
4 expected its revenues and net income to continue to decline , due to
5 falling sales of its Stacker 2 .0 data compression product . In
6 fact, Stac's business has consistently declined since the public
7 offering and Stac has never again achieved net income or earnings
8 per share that matched those reported for the quarter ended March
9 31, 1992. By 1993, Stac was reporting large losses, the firing o f
10, 20% of its employees and a shrinkage of its business . The chart
11 below shows the collapse of Stac's business after the May 7, 1992
12 public offering :
13 Quarter Ended (All amounts in thousands, except EPS) 14 12/31/91 3/31/92 6/30/92 9/30/92 12/31/92 3/31/93 6/30/93 9/30/93 15 Revenue $5,393 $11,664 $10,000 $ 6,200 $12,300 $11,000 $ 5,700 $ 7,700 16 Net Income. 857 4,200 2,700 526 2,100 1,000 (2,300) (420) 17 Earnings 18 Per Share N/A .17 .11 .02 .08 .04 ( .10) ( .02)
19 16 . Stac stock -- sold to the public at $12 per share in May 20 1992 -- collapsed to $5 per share in late July 1992 and declined to 21 just $3 per share shortly thereafter, and ultimately to a low of 22 $1-3/4 per share . The chart below shows the price action of. Stac 23 stock from May 7, 1992-September 20, 1992 : 2 4
25
26
27
28
- 12 - 1 1 6 2 14 3
4 12 ,tac Electronic s day 8, 1982 - September 20, 1992 5 1o ,verage Weeky Price Action
6 CL
7
8 6
9 4 10 9 31Jul 2e-Aug .11 May 05-Jun -Jul. 03'
12
13
14
15 JURISDICTION AND VENU E
16 17 . This court has jurisdiction over the subject matter of
17 this action pursuant to §22 of the Securities Act of 1933 (the
18 "Securities Act") (15 U .S .C . §77v], §27 of the Securities Exchange
19 Act of 1934 (the "Exchange Act") [15 U .S .C . §78aa], and 28 U .S .G .
20 §1331 . The claims asserted herein arise under §§11 and 15'of the
21 Securities Act (15 U .S .C . S§77k and 77o], SS10(b) and 20(a) of the
22 Exchange Act [15 U .S .C . §§78j(b) and 78t(a)], and Rule 10b-5
23 promulgated thereunder by the Securities. and Exchange Commission
24 ("SEC") .
25 18 . Venue is proper in this District pursuant to §22 of the
26 Securities Act, §27 of the Exchange Act and 28 U .S .C . §1391(b) .
27 Many of the acts and transact ions 'giving rise to the violations of
28 law complained of herein, including the preparation and dissemina-
- 13 - 1 tion to the investing public of false and misleading information,
2 occurred in this District . Stac has its principal place of
3 business at 5993 Avenida Encinas, Carlsbad, California 92008 .
4 19 . In connection with the acts, conduct and other wrongs
5 complained of, the defendants, directly or indirectly, used the
6 means and instrumentalities of interstate commerce, the United
7 States mails, and the facilities of the national securities market .
8 THE PARTIES
9 20 . Plaintiff Timothy J . Anderson purchased shares of Stac
10 common stock on May 7, 1992 which stock was issued-and distributed
11 pursuant to the Registration Statement and Prospectus .
12 21 . Plaintiffs Neil Singer and Arthur Singer each purchased
13 400 shares of Stac common stock on July . 15, 1992 at $9 .75 per share
14 which stock was issued and distributed pursuant to the Registration
15 Statement and Prospectus .
16 22 . Defendant Stac Electronics designs, develops and markets
17 data compression software . Data compression technology increases
18 the data storage capacity of computers . The Company's products are
19 sold directly to end users and through retail and distribution
20 channels .
21 23 . (a) At all times material hereto, defendant Gary W . Clow
22 ("Clow") has been Chairman of the Board and Chief Executive officer
23 of Stac . On May 7, 1992, Clow sold 200,000 shares of common stock
24 to the public by means of the false and misleading Registration
25 Statement and Prospectus for $12 .00 per share, realizing $2 .4
26 million . Clow signed the Stac Registration Statement .
27 (b) At all times material hereto, defendant Douglas L .
28 Whiting ("Whiting") has been Vice President of Technology and a
- 14 - 1 director of Stac . On May 7, 1992, Whiting sold 200,000 shares of
2 common stock to the public by means of the false and misleading
3 Registration Statement and Prospectus for $12 .00 per share,
4 realizing $2 .4 million . Whiting signed the Stac Registration
5 Statement .
6 (c) At all times material hereto, defendant Robert W .
7 Johnson ("Johnson") has been a director of Stac . On May 7, 1992,
8 Johnson sold 100,000 shares of common stock to the public by means
9 of the false and misleading Registration Statement and Prospectu s
10 for $12 .00 per share, realizing . $1 .2 million . Johnson owned '2 .2
11 million shares of Stac stock -- 10 .2% of its stock at the time of
12 the Offering . Johnson signed the Stac Registration Statement .
13 (d) At all times material hereto, defendant Arthur J .
14 Collmeyer ("Collmeyer") has been a director of Stac . On May 7,
15 1992, Collmeyer sold 8,000 shares of common stock to the public by
16 means of the false and misleading Registration - Statement and
17 Prospectus for $12 .00 per share, realizing $96,000 . Collmeyer
18 signed the Stac Registration Statement and was a member of Stac's
19 Audit Committee .
20 (e) At all times material hereto, defendant John R .
21 Witzel ("Witzel") has been Vice President of Finance and Operations
22 and Chief Financial Officer of Stac . He signed the Registration
23 Statement . Witzel sold 30,000 shares of common stock to the public
24 by means of the false and misleading Registration Statement and
25 Prospectus for $12 per share, realizing $360,000 .
26 (f) Defendants Lawrence G . Finch ("Finch"), Robert A .
27 Hoff ("Hoff"), and Russell J . Robelen ("Robelen") were each
28 directors of Stac at all relevant times and each of them signed the
- 15 - 1 Registration Statement . Hoff and Johnson were also members of
2 Stac's Audit Committee .
3 (g) Defendant Finch has been a general partner of
4 defendant Sigma Management, a,California limited partnership, and
5 Sigma Management II, L .P ., the general partners of several venture
6 capital funds, including Sigma Partners, a shareholder of the
7 Company since 1989, and he served as its agent and representative
8 on Stac's Board, regularly reporting to it as to his activities in
9 that regard and his knowledge gained in that capacity . Thi s
10 venture capital firm owned 3,250,000 shares of Stac stock at the
11 time of the public offering -- 14 .8% of Stac's stock -- and was a
12 controlling shareholder and person of Stac and Finch .
13 (h) Defendant Hoff has been a general partner of
14 defendant Crosspoint Venture Partners, a private venture capital
15 firm, since 1983, and he served as its agent and representative on
16 Stac's Board, regularly reporting to it as to his activities in
17 that regard and his knowledge gained in that capacity . This
18 venture capital firm owned 4,500,000 shares of Stac stock at the
19 time of the public offering, 20 .4% of Stac's stock, and was a
20 controlling shareholder and person of Stac and Hoff .
21 (i) Defendant Robelen has been a general partner of
22 defendant Idanta Partners since 1983, and he served as its agent
23 and representative on Stac's Board, regularly reporting to it as to
24 his activities in that regard and his knowledge gained in that
25 capacity . This venture capital firm owned 2,475,000 shares of Stac
26 stock at the time of the public offering, 11 .2% of Stac's stock,
27 and was a controlling shareholder and person of Stac and Robelen .
28
- 16 - 1 (j) Defendants Sigma Management, Sigma Management II,
2 L .P ., Sigma Partners , Crosspoint Venture Partners and Idanta
3 Partners are named defendants in their capacity as controlling
4 shareholders of Stac and their representatives on Stac's Board of
5 Directors and as principals who each had agents who sat as their
6 representatives on the Stac Board . They are collectively referred
7 to herein as the "Venture Capital Firm defendants . "
8 (k) By reason of their positions , the officer and/or
9 director . defendants identified in 1 23 (a)-(i) (collectively the
10 "Individual Defendants ") had access to adverse material non-public
11 information about Stac and were able to control directly or
12 indirectly the acts of Stac and the contents of the statements
13 disseminated during the Class Period by or in the name of Stac .
14 24 . At all times material hereto , each of the Individual
15 Defendants was the agent of each of the other Individual Defendants
16 and of Stac , and was at all times acting within the course and
17 scope of said . agency . The Individual Defendants all held the
18 positions indicated . during the Class Period .
19 25 . The Individual Defendants all participated in the
20 drafting and preparation of the Prospectus and Registration
21 Statement and the various public and other communications
22 complained of herein and were aware of or recklessly disregarded
23 the misstatements contained therein and omissions therefrom, and
24 were aware of their materially misleading nature . Because of their
25 Board membership and/or executive and managerial positions with
26 Stac , each of the Individual Defendants had access to the adverse,
27 non-public information about Stac's business prospects and finan-
28 cial condition as particularized herein . Each of the Individual
- 17 - 1 Defendants, by reason of his stock ownership, management position,
2 and/or membership on Stac's Board of Directors, was a controlling
3 person of Stac and had the power and influence, and exercised'the
4 same, to cause Stac to engage in the illegal practices complained
5 of herein .
6 26 . In addition, the Individual Defendants, except Witzel, by
7 reason of their stock ownership and their status as officers and/or
8 directors of Stac were "controlling persons" within the meaning of
9 §15 of the Securities Act and §20 of the Exchange Act . Because. of
10 their positions of control, these defendants were able to and did
11 directly or indirectly, control the conduct of Stac's business, the
12 information contained in the filings with the SEC and public
13 statements about its business .
14 27 . The Individual Defendants, because of their positions of
15 control and authority as officers and/or directors of the Company
16 were able to and did control the contents of the Prospectus and
17 Registration statement, press releases, and presentations to
18 securities analysts pertaining to the Company . Each Individual
19 Defendant was provided with copies of Stac's press releases and SEC
20 filings alleged herein to be misleading prior to or shortly after
21 their issuance and had the ability and opportunity to prevent their
22 issuance or to cause them to be corrected . Because of their Board
23 membership and/or executive and managerial positions with Stac,
24 each Individual Defendant had access to the adverse, non-public
25 information about Stac's business particularized herein, via access
26 to internal corporate documents, conversations or connections with
27 the corporate officers, employees, attendance at Stac's management
28 and Board of Directors meetings and committees thereof and via
- 18 - 1 reports and other information provided to them in connection
2 therewith . As a result, each of these defendants was responsible
3 for the accuracy of the public reports and releases detailed herein
4 as "group published" information and is therefore responsible and
5 liable for the representations contained therein .
6 28 . (a) Defendant Alex . Brown & Sons, Inc . ("Alex . Brown")
7 is a broker/dealer and securities underwriting firm headquartered
8 in Baltimore, Maryland . Pursuant to an Underwriting Agreement,
9 Alex . Brown acted as one of the Co-lead Underwriters with respec t
10 to the sale of the common stock of Stac pursuant to the
11 Registration Statement and Prospectus . Alex . Brown received
12 substantial fees in connection . with the Offering of the common
13 stock of Stac .
14 (b) Defendant Montgomery Securities ("Montgomery") is a
15 broker/dealer and securities underwriting firm headquartered in
16 San Francisco, California . Pursuant to an Underwriting Agreement,
17 Montgomery acted as one of the Co-lead Underwriters with respect to
18 the sale of Stac common stock pursuant to the Registration
19 Statement and Prospectus . 'Montgomery received substantial fees in
20 connection with the offering of the common stock of Stac .
21 (c) During the Class Period Alex . Brown and Montgomery
22 acted as agents for Stac, and helped to support (inflate) the price
23 of Stac stock in the aftermarket by creating -- with Stac's help --
24 and issuing false and misleading securities analysts' reports on
25 Stac .
2.6 (d) As part of the Offering, Alex . Brown and Montgomery
27 (collectively the "Underwriter Defendants") conducted or parti-
28 cipated in an investigation, known as a "due diligence" investi-
- 19 - 1 gation, into the business, operations, and prospects of Stac, as
2 well as the Company's financial condition, accounting and
3 management control systems . In the course of such investigation,
4 Alex . Brown and Montgomery either obtained knowledge of, or
5 recklessly disregarded or failed to perform reasonable due
6 diligence sufficient to discover the facts set forth herein . Alex .
7 Brown and Montgomery were agents of the Company through which Stac
8 common stock was sold in the Offering . In order to help sell the
9 Offering, the underwriters arranged and conducted a "Road Show" a
10 few weeks before the May 7, 1992 public offering, during which they
11 and Stac's top officers visited several U .S . cities (including New
12 York, Chicago and San Francisco) and met with institutional
13 investors, securities analysts and others to present favorable
14 information about Stac to create demand for its stock to be sold on
15 the Offering . In addition, the Underwriter Defendants acted as
16 market-makers for Stac common stock and issued research reports to
17 the investment community which described the financial and business
18 prospects of Stac . In these various capacities, defendants Alex .
19 Brown and Montgomery had access to material non-public information
20 about Stac's business, finances, products and future business
21 prospects . The Underwriter Defendants violated the federal
22 securities laws, as alleged herein, in part, to obtain their share
23 of the $2 .5 million in fees the underwriters received from the
24 proceeds .of the Offering .
25 DUTIES OF STAC'S OFFICERS AND DIRECTOR S
26 29 . Stac and each officer and director of Stac owed to its
27 shareholders and the investing public in general the duty to
28 exercise due care and diligence in the management and administra-
- 20 - 1 tion of the affairs of Stac, as well as the duty of full and candid
2 disclosure of all material facts related thereto . In addition,
3 under federal and state law, these defendants owed prospective
4 purchasers of Stac common stock the duty to exercise care that
5 public statements regarding the Company, its business, its
6 management, its products, its internal controls and management
7 information systems, its markets and present and future business
8 prospects would be complete, accurate and truthful and not in any
9_ way materially misleading . To discharge their duties, th e
10 Individual Defendants were required to exercise reasonable and
11 prudent supervision over the management, policies, practices and
12 financial controls of Stac . By virtue of such duties, these
13 officers and directors of Stac were required, inter alia :
14 (a) To manage, conduct, supervise and direct the
15 business and affairs of Stac in accordance with the laws of the
16 State of California, federal law, state and federal rules and
17 regulations and the Articles and By-laws of Stac ;
18 (b) To neither violate nor knowingly or recklessly
19 permit any officer, director or employee of Stac to violate
20 applicable federal laws, rules and regulations, including federal
21 and state securities laws ;
22 (c) To establish and maintain systematic-and accurate
23 books and records of the business and affairs of Stac and
24 procedures for reporting Stac's business and affairs to Stac's
25 Board of Directors and to periodically investigate, or cause
26 independent investigation to be made, of said books and records ;
27 (d) To maintain and implement an adequate and
28 functioning system of internal financial, accounting and inventory
- 21 - 1 controls and management information systems, such that Stac's
2 financial statements and information would,be accurately recorded
3 and reported and corporate managers would be given prompt notice of
4 serious problems so that such problems could be adequately
5 addressed, resolved and disclosed and so that risk to Stac and its
6 investors would be minimized ;
7 (e) To supervise and review the preparation and filing
8 of any audits, reports, or other information required by law from
9 Stac, including the Company's Prospectus and 'Registratio n
10 Statement, Forms 10-K, 10-Q, and proxy statements and to examine,
11 evaluate and approve any reports of examination, audits or other
12 financial "group published" information concerning the financial
13 affairs and condition of Stac and to make full and accurate
14 disclosure of all material facts concerning, inter alia s each of
15 the subjects set forth above ;
16 (f ) To refrain from either obtaining personal benefit at
17 the expense of the public security holders of Stac, or misusing
18 proprietary non-public corporate information ; and
19 (g) Under rules and regulations promulgated by the SEC
20 under the Exchange Act, specifically Item 303 of Regulation S-K,
21 the Individual Defendants also had a duty to report all known
22 trends, events or uncertainties that were reasonably likely to : (i)
23 impact Stac's liquidity ; (ii) impact Stac's net sales, . revenue
24 and/or income ; and/or (iii) cause previously reported financial
25 information to not be necessarily indicative of future operating
26 results . The Individual Defendants' representations and non-
27 disclosures during the Class Period violated these specific
28 requirements and obligations .
- 22 - 1 30 . During the Class Period, each of the Individual
2 Defendants occupied positions with Stac or were associated with the
3 Company in such a manner as to make them privy to confidential
4 proprietary information concerning Stac, its operations, finances,
5 financial condition, products and present and future business
6 prospects . Because of these positions and such access, each of
7 these defendants knew or recklessly disregarded that the adverse
8 facts specified herein had not been disclosed and were being
9 concealed from the public .
10 31 . Notwithstanding their duty to refrain from selling Stac
11' common stock while in the possession of material, adverse, non-
12 public information concerning Stac, each of the Individual
13 Defendants sold shares of the Company's common stock during the
14 Class Period .
15 FRAUD-ON-THE-MARKET DOCTRIN E
16 32 . The market price for Stac stock is reflective of and
17 efficient market for the following reasons, among others :
18 (a) Stac met the "requirements for listing, and was
19 listed on the NASDAQ National Market System, a highly efficient and
20 automated market ;
21 (b) Stac files periodic public reports with the SEC and
22 NASDAQ ;
23 (c) Stac's trading volume was substantial, averaging
24 150,000 shares a day during the Class Period thereby reflecting
25 numerous trades each day ; and
26 (d) Stac was followed by analysts employed by brokerage
27 firms who wrote reports which were distributed to the sales force
28 and certain customers of their respective brokerage firms and which
- 23 - 1 were available publicly through various automated data retrieval
2 services .
3 PLAINTIFFS' CLASS ALLEGATION S
4 33 . Plaintiffs bring this action as a class action pursuant
5 to Federal Rules of Civil Procedure 23(a) and (b)(3) on behalf of
6 all persons who purchased the common stock of Stac from May 7, 1992
7 through July 20, 1992 (the "Class Period") . Excluded from the
8 Class are the defendants herein, members of the immediate family of
9 each of the Individual Defendants, any entity in .which any defen-
10 dant has a controlling interest, . and the legal representatives,
11 heirs, successors or assigns of any such excluded party .
12 34 . (a) Members of the Class are so numerous that joinder of
13 all members is impracticable . While the exact number of Class
14 members is unknown to plaintiffs at the present time, Stac issued
15 3 million shares of common stock pursuant to the Offering and which
16 were acquired by hundreds or thousands of shareholders throughout
17 the country .
18 (b) Plaintiffs' claims are typical of the claims of the
19 Class because plaintiffs and all the Class members sustained
20 damages which arose out of the defendants' wrongful *conduct
21 complained of herein .
22 (c) Plaintiffs are representative parties who will fully
23 and adequately protect the interests of the class members .
24 Plaintiffs have retained counsel who are experienced and competent
25 in both class action and securities litigation . Plaintiffs have no
26 interest which is contrary to or in conflict with those of the
27 Class they seek to represent .
28
- 24 - 1 (d) A class action would be superior to all other
2 available methods for the fair and efficient adjudication of this
3 controversy . Plaintiffs know of no difficulty to be encountered in
4 the management of this action that would preclude its maintenance
5 as a class action .
6 (e) The prosecution of separate actions by individual
7 Class members would create a risk of inconsistent and varying
8 adjudications concerning the subject of this action, which
9 adjudications could establish incompatible standards of conduct fo r
10 defendants under the laws alleged herein . Further, questions of
11 law and fact common to the members of the Class predominate over
12 any questions which may affect only individual members in that
13 defendants have acted-on grounds generally applicable to the entire
14 Class . Among the questions of law and fact common to the Class
15 are :
16 (i) Whether the federal securities laws were
17 violated by defendants' acts as alleged herein ;
18 (ii) Whether Stac's publicly disseminated statements
19 during the Class Period misrepresented and/or omitted material
20 facts ;
21 (iii) Whether defendants participated in and pursued
22 the common course of conduct complained of herein ;
23 (iv) Whether defendants are strictly liable for the
24 misrepresentations in the Prospectus ;
25 (v) Whether defendants acted willfully or
26 recklessly in misrepresenting and/or omitting material facts or in
27 aiding and abetting the making of such misstatements ;
28
- 25 - (vi) Whether the market prices of Stac common stock
2 during the Class Period were artificially . inflated due to the
3 misrepresentations and/or nondisclosure complained of herein ; and
4 (vii) The extent of losses sustained by members of
5 the Class and the appropriate measure of damages .
6 SUBSTANTIVE ALLEGATIONS
7 35 . By 1990, millions of personal computers using the MS-DOS
8 or comparable operating systems existed and appeared to provide a
9 large potential market for Stac's Stacker products . Because Stac
10 was first to market with a data compression product, during 1991,
11 sales of Stac's Stacker products exploded as users of personal
12 computers found Stac's data compression products an inexpensive and
13 effective way to increase the data storage capacity of the MS-DOS
14 operating systems of their computers . This led to Stac achieving
15 significant growth in its revenues, and net income, as well a s
16 earnings per share through December 31, 1991 .
17 36 . By late 1991, 90% of Stac's revenues and over 90% of its
18 profits came from the sale of its Stacker 2 .0 data compression
19 product . Because the then currently available versions of
20 Microsoft's MS-DOS operating system did not have data compression
21 capability, the sale of Stacker 2 .0 to owners of personal . computers
22 using the MS-DOS operating system and purchasers of new computers
23 which came with the MS-DOS operating systems was the main market
24 for Stac's Stacker 2 .0 product . However, Stac's business would be
25 severely injured if not destroyed if Microsoft included data
26 compression capability in its MS-DOS operating system (which
27 Microsoft periodically updated), as computer owners using the MS-
28 DOS system could then obtain data compression capability at no
- 26 - 1 extra, cost merely by obtaining the upgraded MS-DOS operating system
2 and purchasers of new personal computers supplied with the MS-DOS
3 operating system would obtain that capability upon purchase of
4 their computer' and have no need to purchase separate software
5 providing such capability .
6 37 . As a result of the niche in the personal computer
7 software market Stac was exploiting, its revenue and net income
8 exploded in the latter part of calendar 1991 and early 1992 .
9 However, Stac's top executives knew by late 1991 or early 1992 tha t
10 Stac's competitive position was being impaired and. that its strong
11 growth in revenues and earnings would shortly come to an end
12 because of softening demand for its Stacker 2 .0 product, the
13 increased availability of effective and low priced competitive
14 compression data products and because they had learned that
15 Microsoft intended to include data compression capabilities in its
16 next version of its MS-DOS operating system, which it was then
17 currently developing and intended to commence and release as soon
18 as possible in 1992, and that this data 'compression capability
19 would be included at no additional cost in Microsoft's upgraded MS-
20 DOS system .
21 38 . This situation posed a serious threat to Stac, its
22 insiders and controlling shareholders . Because their stockholdings
23 in Stac were illiquid and they had no way to sell their stock to
24 lessen the adverse impact the coming decline in Stac's business
25 would have on their holdings, Stac's insiders could not sell their
26 Stac shares privately, as potential buyers in a private sale would
27 be sophisticated and would know of or learn of Stac's deteriorating
28 competitive position and its poor future prospects, during the pre-
27 - 1 purchase due diligence investigation they would have to be
2 permitted to undertake . Since they could not sell their Stac stock
3 privately, the insiders pursued a public offering of Stac stock
4 whereby the stock would be sold to public investors, thereby
5 raising large amounts of money for Stac and its insiders . They
6 also knew that once these adverse conditions began to manifest
7 themselves publicly, it would be impossible to sell Stac stock in
8 a public offering . Thus, Stac's insiders decided to undertake a
9 public offering of stock of the corporation, part of which was t o
10- be issued, by the corporation . and part of which was to be . sold by
11 insider and controlling stockholders in an effort . to raise capital
12 for the corporation to cushion it against the impending decline of
13 its business and allow the insiders to cash out of some of their
14 illiquid Stac stock before these adverse facts became public
15 knowledge, which they knew would result in them not being able to
16 complete a public offering of Stac stock .
17 39 . Upon learning of Microsoft's decision to include
18 compression data capability in its soon to be announced upgraded
19 . MS-DOS operating system software, Stac's insiders knew that any
20 such disclosure would make the public offering they were
21 contemplating impossible to achieve . . Therefore, to delay such an
22 announcement by Microsoft and to permit them to complete the public
23 offering before this adverse information became public, Stac's
24 insiders commenced a negotiation with Microsoft to license to
25 Microsoft Stac's data compression technology, so that Microsoft
26 could utilize that technology, to create . the data compression
27 capability in its improved MS-DOS operating system . Although Stac
28 realized that to license its technology to Microsoft for such
- 28 - 1 purposes would also have a negative impact on its revenue growth
2 and profitability, as it would diminish the market for its own data
3 compression products, it nevertheless continued these negotiations
4 because it never intended to reach-any agreement with Microsoft ;
5 but rather, only to tie Microsoft up in negotiations for a long
6 enough time to permit Stac to pull'off its public offering before
7 Microsoft announced its decision to include data compression
8 capability in its next upgrade of the MS-DOS operating system .
9 'Thus, during late 1991 through the date of Stac's public offering ,
10 Stac's top officers engaged in continuous negotiations with
11 Microsoft, during which negotiations they were repeatedly informed
12 by Microsoft that Microsoft was actively working on creating its
13 own data compression capability and that regardless of how the
14 negotiations with Stac turned out, Microsoft had decided to include
15 data compression capability in its next upgraded version of its MS-
16 DOS operating system, which would be released as soon as possible
17 in 1992 .
18 40 . In addition to attempting to delay any announcement of
19 Microsoft's decision to include data compression capability in its
20 upgraded MS-DOS operating system, Stac's insiders also undertook
21 action to artificially inflate Stac's reported results for the last
22 period (ending March 31, 1992) that would appear in the Prospectus,
23 so as to make it appear that Stac was continuing to enjoy strong
24 demand for its data compression products and achieving strong
25 growth in revenues and profits, thus concealing that demand for its
26 most important product had, in fact, weakened . This was achieved
27 by Stac offering certain of its customers special terms beyond
28 those it normally extended to induce them to order extra amounts of
- 29 - 1 Stac's data compression products prior to March 31, 1992, including
2 special price discounts and unlimited and/or expanded rights of
3 return if the products were not resold . These activities were not
4 the normal "channel fill" which customarily follows the
5 introduction of a new product, but rather, extraordinary and
6 unusual efforts to boost the sales of a product, demand for which
7 was softening . By so doing, Stac improperly recorded revenues and
8 understated its required reserves and thus materially overstated
9 its net income and . earnings per share for the period ended Marc h
10 31, 1992 . Because Stac had by these actions "borrowed" large
11 amounts of sales from future periods,Stac's insiders knew this
12 virtually guaranteed that Stac's financial results following March
13 31, 1992, would decline sharply from those reported for the March
14 31, 1992 period and in fact, by the time of the public offering
15 Stac sales were already softening, in part because customers were
16 already returning product purchased on special incentive terms
17 prior to March 31, 1992, or refusing to order additional products,
18 as they did not -need any . In addition, by so doing, Stac's
19 insiders exposed the corporation to substantial liability under its
20 secret and undisclosed price protection obligation to its
21 distributors, further insuring that Stac's future financial results
22 would decline sharply after March 31, 1992 .
23 41 . Stac, its insiders and controlling shareholders thus
24 retained Montgomery and Alex . Brown to help them and act as Stac's
25 agents in the Offering and to help boost or support Stac's stock in
26 the aftermarket . They obtained commitments that Montgomery and
27 Alex . Brown would . help them prepare a Prospectus which would
28 present the Company in an attractive manner and assist in marketing
30 1 the stock via a "Road Show" whereby Stac . and its top officers
2 (specifically, Clow and Witzel) would make highly favorable
3 presentations to potential investors to help create strong demand
4 for the stock . Stac and its insiders also secured commitments from
5 Montgomery and Alex . Brown that after the offering, analysts from
6 those firms would issue favorable reports on Stac which would
7 support Stac stock in the aftermarket, i.e ., " booster shots ." For
8 this the Underwriters would be paid over $2 .5 million by Stac, its
9 insiders and its controlling shareholders- out of the Offering
10 proceeds . The Offering was also extremely . .beneficial to Stac and
11 the insiders, enabling them to obtain large amounts of cash which
12 none of them could have otherwise obtained .once the truth about
13 Stac's business came out . In addition, because'Stac's business was
14 about to decline, the stock sale was very beneficial to its
15 insiders and controlling shareholders, as the cash received by Stac
16 in the Offering . would help insulate it and its insiders to a
17 substantial degree from the adverse effects the coming decline
18 would have on Stac's business, as it would give Stac cash to
19 mitigate the impact of the decline . The cash infusion also pumped
20 up Stac's book value by almost 300% to $1 .02 per share from $ .36
21 per share -- an instant $14 .5 million gain for Stac's insiders and
22 controlling stockholders in the book value of their remaining 22
23 million shares of Stac stock .
24 42 . By the time of the May 1992 Offering, Stac's business .had
25 actually begun to be adversely impacted by the negative factors its
26 insiders and controlling shareholders knew were overtaking it . In
27 order to conceal the negative impact of these factors and .hide the
28 adverse trends hurting Stac's business and its increasingly
- 31 - 1 impaired competitive position, Stac and its insiders took steps to
2 artificially inflate its revenues and net income as of March 31,
3 1992, and the defendants issued a materially false and misleading
4 Prospectus . While the Prospectus contained some cautionary
5 language (which was itself false and misleading), the defendants
6 diluted that language by undertaking an extensive "Road Show" prior
7 to the Offering, i .e ., presentations to prospective investors in
8 several cities, stressing the continued strong demand for its
9 products, its successful development and introduction of ne w
10 products and its strong competitive position, while making bullish
11 forecasts of continued profitable growth through fiscal 1992 and
-12 1993, which presentations were much more positive than the
13 information contained in the Prospectus . This positive information
14 was also distributed to securities houses which were members of the
15 Stock Offering selling group and used by them to create "sales
16 sheets" or "talking points" for presentations by their brokers to,
17 customers to help sell Stac's stock . This operated to create a
18 false and misleading impression concerning Stac and created such
19 demand for the offering that Stac's stock was-viewed as a "hot"
20 offering, thus enabling Stac and its insiders to sell 3 'million
21 shares of stock at $12 per share .
22 43 . The Road Show presentations took place in several U .S .
23 cities, including New York ., Chicago and San Francisco, in the three
24 weeks prior to the May 7, 1992 stock sale . During the Road Show
25 presentations, which included an extensive slide show and oral
26 presentations by Stac executives Clow (CEO) and Witzel (CFO), the
27 following information was provided to potential investors during
28 the Road Show presentations :
- 32 - 1 (a) Stac's .business was strong and demand for its data
2 compression products was stable or increasing ;
3 (b) Stac had achieved extremely strong revenue and
4 earnings growth in the quarter ended March 31, 1992, in part due to
5 favorable publicity for and awards received by its Stacker 2 .0
6 product ;
7 (c) Stac was forecasting continued strong revenue and
8 net income growth in succeeding quarters such that its earnings per
9 share would consistently increase during the balance of fiscal 199 2
10 and -total $ .55 per share, increase in fiscal 1993 to $ .82 per share
11 and reach $1 .15 per share in fiscal 1994 . This same information
12 was in the "sales sheets" and "talking points" . distributed to
13 brokers who worked for members of the underwriting group to help
14 sell the Stac stock .
15 44 . The information presented on the Road Show and in the
16 "sales sheets" and "talking Points" was false and misleading . The
17 true facts, which were concealed, were :
18 (a) Demand for Stac's main compression data product had
19 weakened and that in order to stimulate sales of those products,
20 'Stac was granting special incentive terms, including price
21 discounts and rights of return beyond those it normally granted in
22 the ordinary course of business ;
23 (b) That in order to artificially increase the revenues
24 and net income Stac reported .for the quarter and the six months
25 ended March 31, 1992, Stac induced certain of its customers to
26 order extra merchandise on special terms, which it did not grant in
27 the ordinary course of business, and which Stac knew could not be
28 sold by them in the near term ;
- 33 - 1 (c) That Stac had achieved strong revenue and net income
2 growth in its second quarter of fiscal 1992 ended March 31, 1992,
3 not because its data compression products had received favorable
4 publicity in trade publications and awards but rather due to the
5 special price discounts and sales terms referred to above ;
6 (d) Because Stac had sold significant amounts of data
7 compression products prior to March 31, 1992 on special terms,
8 which included increased rights of return for unsold product,
9 without setting up sufficient reserves for later returns o f
10 product, Stac's revenues and net income for that period were
11 materially overstated ;
12 (e) Because- demand for Stac's main product was
13 weakening, because Stac had "borrowed" sales from future periods to
14 . artificially inflate its March 31, 1992 financial results, and
15 because Microsoft would soon be announcing an enhanced version of
16 its MS-DOS operating system that would include data compression
17 capability at no extra cost, Stac's revenues, net income and
18 earnings per share would fall substantially following the public
19 offering ; and
20 (f) There was no reasonable basis in fact for the
21 forecasts of increased earnings per share in fiscal 1992-1994, for
22 Stac, which forecasts were, in fact, contradicted by and inconsis-
23 tent with information known only to defendants, due to their access
24 to material non-public information about Stac's business .
25 45 . On May 7, 1992, Stac, its insiders and its controlling
26 shareholders sold three million shares of stock to the public at
27 $12 per share . Of the three million shares, the Company sold
28 1,500,000 shares ; selling stockholders, which included certain
- 34 - 1 defendants-as particularized at ¶23( a)-(e), sold 1,500,000 shares ;
2 all via a Registration Statement and . Prospectus, effective with the
3 SEC on that date .
4 46 . The Prospectus described Stac as follows :
5 Stac Electronics designs, develops, markets and supports data compression products that increase the 6 effective capacity of storage devices and transmission rates of data communications systems . The Company's 7 Stacker LZS technology uses proprietary algorithms to compress and decompress data in an efficient, transparent 8 operation that maintains complete data integrity . The Company has implemented its data compression technology 9 in a variety of software and . semiconductor-based products, including the Stacker family of software and 10 add-in boards that provide convenient, cost-effective and reliable data compression . Introduced in December 1990, 11 the Company's Stacker products generally provide a two- fold increase in effective storage capacity for personal 12 computers that use Microsoft Corporation's MS-DOS or compatible operating systems . Stacker products are full y 13
14
15
16 Stac Electronics designs, develops, markets and 17 supports data compression products that increase the effective capacity of storage devices and transmission 18 rates of data communications systems . The Company's Stacker LZS technology uses proprietary algorithms to 19 compress and decompress data in an efficient, continuous, transparent operation that maintains data integrity . The 2 0 Company has implemented its data compression technology in a variety of software and semiconductor-based 21 products, including the Stacker family of software and add-in boards that provide convenient, cost-effective and 22 reliable data compression . Introduced in December 1990, Stacker products generally provide a two-fold increase in 23
24
25 Background 26 The management, storage and communication of 27 increasingly large amounts of data are key challenges currently confronting computer users and designers . 28
- 35 - 1 * * *
2 These trends have heightened the need for cost-effective solutions to the issues and problems currently associated 3 with the management, communication and storage of ever increasing amounts of data . 4 Historically, there have been a number of approaches 5 to address these problems : active management and main- tenance of files to reduce demands on installed storag e 6 devices with higher capacity storage devices ; . . . or purchase of new systems with higher capacity storage 7 devices .
8 Active file management and maintenance is a low-cost approach to the problem of data storage . It is not an 9 effective solution, however, when data files and appli- cations programs permanently occupy large amounts of 10 storage capacity . Moreover, active file management and maintenance does not address the need for faster, more 11 efficient data communications .
12 The substitution of higher capacity storage devices enables users to increase system storage capacity without 13 buying an entire new system . Hardware upgrades ar e relatively expensive, time-consuming and require computer 14 down-time and file transfers while the upgrade is being put in service . Although new computer systems may offer 15 greater storage capacities than older systems, they do not address the needs of users of installed computers who 16 do not wish to incur the expense of an entire system upgrade . 17
18 47 . The Prospectus presented Stac's financial performance,
19 showing strongly increasing revenues and profits in recent months,
20 without any disclosure that factors then existed that had caused
21 that trend to end, would cause demand for Stac's products to weaken
22 and would result in Stac's revenues, net income and earnings per
23 share declining sharply immediately after its offering . The
24 Prospectus reported :
25 Six Months Fiscal Year Ended Ended 26 September 30, March 31 , 1987 1988 1989 1990 1991 1991 1992 27 Revenues $625 $749 $755 $1,762 $8,390 $2,333 $17,057 28
- 36 - 1 Net incom e (loss) 33 (58) (477) (948) 195 (983) 5,074 2 Net incom e 3 (loss) per share - ( .01) ( .03) ( .05) .01 ( .04) .2 1 4
5 With respect to Stac's quarterly results, the Prospectus reported :
6 Quarter Ende d June 30, September 30, December 31, March 31, 7 1991 1991 1991 199 2
8 Revenues $2,991 $ 3,066 $5 ,393 $11,66 4
9 Net income - 12 396 2,638 $ 895 $ 283 $ 857 $ 4,21 7 10
11 48 . The Prospectus explained these favorable financia l
12 results as follows :
13 Revenues increased in each of the last six quarters . The auarterlv increases in revenues have been due primar- 14 ily to increased demand for Stacker products, which the Company believes was the result of increased marketing 15 and selling efforts and the expansion of distribution channels during the second and third quarters of fiscal 16 1991 to include national distributors and resellers . The Company . believes that revenues in the fourth quarter of 17 fiscal 1991, which were slightly higher than in the pre- ceding quarter, were negatively affected by anticipation 18 in the distribution channel of the release of new ver- sions of Stacker products in late-September 1991 . The 19 Company believes that the increase in revenues in the second quarter of fiscal 1992 resulted partially from 20 awards and reviews published in that quarter .
21 The company believes that substantially all of its Stacker revenues to date have resulted from sales to new 22 customers as opposed to purchases of upgrades by existing customers . The Company . sells substantially all of its 23 products based on an established discount structure, which has not varied significantly from quarter to 24 quarter . The Company does not believe that its dis- counting activities have significantly affected revenues 25 or results of operations in any given period .
26 49 . These statements were false and misleading . The true 27 facts , which were concealed, were : 28
- 37 - 1 (a) Stac's March 31, 1992 financial statements
2 overstated Stac's revenues, net income and earnings per share as
3 detailed elsewhere in this complaint ;
4 (b) The Company's LZS technology did not use proprietary
5 algorithms and, in fact, key parts of such technology were in the
6 public domain and could be utilized by others to quickly and
7 cheaply create competitive products ;
8 (c) That Stac had learned that Microsoft had decided to
9 include (at no, extra . cost) data compression capability
10 ("DoubleSpace") in its .next version of its MS-DOS operating system
11 which it intended to announce and introduce as soon as possible in
12 1992 ;
13 (d) That Stac was attempting to delay Microsoft's
14 announcement that it had decided to include data compression
15 capability in Microsoft's enhanced MS-DOS operating system to be
16 introduced as soon as possible in 1992 ;
17 (e) Demand for Stac's main compression data product
18 (Stacker 2 .0) had weakened, due in part to the introduction of a
19 new and successful competitive product,- and that in order to
20 stimulate sales of those products, Stac was granting special sales
21 incentive terms, including price discounts and rights of return
22 beyond those it normally granted in the ordinary course of
23 business ; .
24 (f) That in order to inf late the revenues and net income
25 Stac reported for the quarter and the six months ended March 31,
26 1992, Stac had induced certain of its customers to order extra
27 merchandise on consignment terms, which it did not grant in the
28 ordinary course of business, and which were not bona fide sales ;
- 38 - 1 (g) That in order to stimulate sales of its products at
2 the end of the quarter ended March 31, 1992, Stac was granting
3 special discount prices to selected customers which, combined with
4 price cuts which Stac anticipated making publicly, would trigger
5 substantial liability of Stac under the price protection agreements
6 it had with its customers ;
7 (h) That Stac had achieved strong revenue and net income
8 growth in its second quarter of fiscal 1992 ended March 31, 1992,
9 not because its Stacker 2 .0 data compression product had received
10 favorable publicity in trade publications and awards but rather,
11 due to the special price discounts and sales terms referred to
12 above ;
13 (i) Because Stac had "borrowed" sales from future
14 periods in order to artificially inflate sales of its data
15 compression -products prior to March 31, 1992, and because Stac knew
16 Microsoft would soon be announcing an enhanced MS-DOS operating
17 system which included data compression capability, Stack's revenues
18 and net income were going to decline sharply ;
19 (j) That because of the factors set forth above, Stac's
20 business had peaked and was entering a period of protracted
21 decline, whereby the Company's profits and, earnings per share would
22 decline to levels well below those achieved in the recent past ;
23 (k) That Stac's business was entering an extremely
24 difficult period characterized by increased competition and
25 decreased selling prices for Stac's products, such that Stac would
26 suffer a serious decline in its business ;
27 (1) That Stac's main product line -- data compression
28 products -- would soon be severely disadvantaged in the marketplace
- 39 - 1 by Microsoft' s announcement of an improved MS-DOS operating system
2 that would include data compression capability at no additional
3 costs, thus ending Stac's ability to achieve continued profitabl e
4 growth ; and
5 (m) That Stac' s profits had peaked during the first
6 quarter of calendar 1992 and because of the factors stated above ,
7 had entered a period of protracted decline .
8 50 . With . respect to marketing and sales , the Prospectus
9 stated :
-10 The Company's return Policy allows its distributors t o ve 4-11- ter. . . r. - . . r .- -A --^A,ir 4- 4 .- 4- 1- - i c4-r4i 'k»i- ^ v.! ~ 11
12 any version of a product, for a credit or cash refund . In addition, distributors may participate quarterly in a 13 stock balancing program which, subject to certain limitations, allows them to return purchased products 14 within the second month of each calendar quarter for full credit towards future purchases . The Company believes 15 that this stock balancing provision is customary in the industry and should not materially increase risks 16 associated with the relationship given its limited nature . End users may return defective products pursuant 17 to policies established by their dealer . The Company will make a refund or exchange at cost through the 18 dealer's distributor . Although the Company believes that it provides adequate allowances for returns, there can be 19 no assurance that actual returns in excess of recorded allowances will not result in a material adverse effect 20 on the Company's business, operating results or financial condition . 21
22 51 . These statements were false and misleading . The true
23 facts, which were concealed, were :
24 (a) Because demand- for Stac's main compression dat a
25 products had weakened and in order to stimulate sales of thos e
26 products, Stac -was granting special sales incentive terms includin g
27 rights of return beyond those it normally granted ;
28
r - 40 - 1 (b) Because Stac had sold significant amounts of data
2 compression products prior to March 31, 1992 on special . terms,
3 granting increased rights of return for unsold product without
4 increasing Stac's reserves for such returns, Stac knew that its
5 existing reserve for returns was inadequate and that this would
6 require Stac to take increased reserves as charges to earnings in
7 the future as those special rights of return were exercised as Stac
8 knew they would be, thus adversely affecting Stac's results from
9 operation in the near future ; and
10 (c) That in order to stimulate sales of its products,
11 Stac" . .was 'offering special discount prices to selected large
12 customers which, when combined with price cuts which Stac was
13 anticipating making publicly, would trigger substantial liability
14 of Stac under its price protection agreements with its customers,
15 thus adversely affecting Stac's results from operations in the near
16 future .
17 52 . With respect to Stac's competitive position, the
18 Prospectus stated, in part :
19 The Company believes that the primary competitive factors in the personal computer data compression product 20 market are product features and performance, produc t compatibility and reliability, ease of use, product 21 reputation, price, timeliness of product upgrades and the quality of customer support and service . The Company 22 believes that its Stacker products provide a combination of speed and data compression that is superior to the 23 performance of competing products . The Company believe s that its Stacker products are easier to use and generally 24 utilize less memory than competing products . Certain of the competing products compete favorably with th e 25 Company's Stacker products with respect to price and one competing product competes favorably with respect to 26 compression speed in a software-only product offering . Although to date price competition has not been a major 27 factor for the Company's products, it may become a significant factor in the future . 28
- 41 - 1 53 . These statements were false and misleading . The true
2 facts, which were concealed, were :
3 (a) Demand for Stac's main compression data products
4 (Stacker 2 .0) had weakened, in part due to`the introduction of a
5 new and successful competitive product ;
6 (b) That Stac had learned that Microsoft had decided to
7 include (at no extra cost) data compression capability
8 ("DoubleSpace") in its next version of its MS-DOS operating system
9 which it intended to announce soon and introduce as soon as
10 possible in 1992 ;
11 (c) That in order to stimulate sales of its products at
12 the end of the quarter ended March 31, 1992, Stac was . granting
13 special discount prices to selected customers which, combined with
14 price cuts which Stac anticipated making publicly, would trigger
15 substantial liability of Stac under the price protection agreements
16 it had with its customers ;
17 (d) The market for Stac's data compression products was
18 not as large or as promising as represented due to the growing
19 success of competitive products and the fact that Microsoft had
20 decided to include data compression capability in its next upgraded
21 version of its MS-DOS operating system ; and
22 (e) Stac's information confirmed that its main product
23 line would, in essence, be obsoleted by Microsoft's introduction of
24 its enhanced MS-DOS operating system, including data compression
25" capability, making successful expansion and continued profitable
26 growth for Stac impossible .
27 54 . As to the purpose of the stock offering, the Prospectus
28 stated :
- 42 - 1 The principal purposes of this offering are to increase the Company's equity capital to create a public marke t 2 for the Common Stock and to facilitate future access by the Company to public equity markets . 3 In discussing the use of proceeds of the public offering, the 4 Prospectus stated : 5 Use of proceeds . . . . . Working capital, product 6 development, expansion of sales, marketing and support 7 organizations, facilities expansion and other general 8 corporate purposes .
9
10 The Company expects to use the net proceeds of this offering for working capital ; to fund product develop- 11 ment ; to increase the Company's sales, marketing and customer support organizations ; for expansion of 12 facilities ; and for general corporate purposes .
13 This language indicated that Stac was selling stock to raise monies 14 to continue the expansion of its business and that investors' 15 monies were going to be used by Stac to expand a successful 16 business and increase its sales and marketing operations . 17 55 . These statements were-false and misleading because they 18 failed to disclose : 19 (a) The primary purpose of the Offering was not "to 20 create a public market for the Company's Common Stock," but rather 21 to raise capital for Stac that it would not be able to raise via a 22 stock sale when the adverse impact of its undisclosed problems as 23 detailed above became apparent to the public ; 24 (b) A principal purpose of the Offering was not to 25 increase the Company's equity capital but to enable certain 26 insiders and controlling stockholders to sell their Stac stock 2 7
28
- 43 - 1 before the-public learned the truth about the . adverse conditions
2 plaguing Stac's business ; and
3 (c) Stac had no real need for additional working capital
4 and had no expectation of significantly expanding any part of its
5 business, but was selling stock to raise cash to buffer itself
6 against the decline in its business it knew was coming and which
7 would make a later stock sale impossible .
8 56 . The Prospectus contained a list of "Risk Factors," which
9 created the illusion of candor, while actually containing
10 . misleading information . These purported "risk" disclosures were
11 themselves false and misleading as they gave the impression that
12 the risks which faced Stac were nothing more than that, i .e ., just
13 risks of things that " may" or "could" occur . In fact, however,
14 several of the conditions presented merely as abstract risks were,
15 at the time of the offering, realities, already adversely affecting
16 Stac's business, as at the time of the Offering its business and
17 profitability had peaked and would soon decline, thus meaning that
18 Stac would suffer declining revenue and sharply declining profits
19 in the near future .
20 57 . Thus, despite its "risk factors" the Prospectus failed to
21 disclose that the Company's current sales and profit sharing were .
22 already being impaired by the success of a new competitive product
23 and weakening demand for its Stac 2 .0 product and that its future
24 prospects had, in fact, already been impaired due to 'Microsoft's
25 decision to include data compression capability in its enhanced
26 version of its MS-DOS operating system which it intended to intro-
27 duce as soon as possible in 1992 and which would sharply reduce the
28 market for, and growth potential of, Stac's main product .
- 44 - 1 58 . The Prospectus contained the following "Risk Factor"
2 language concerning competition :
3 Competition . The market for the Company's products is intensely competitive . A number of competitors offer 4 products that currently compete with one or more of th e Company's products . Other companies in the personal .5 computer industry, such as operating systems vendors, utility software vendors, microprocessor and chip se t 6 suppliers, disk drive manufacturers and personal computer manufacturers, could seek to expand their product 7 offerings by designing and selling products using competitive data compression or other technology that 8 could render obsolete or adversely affect sales of the Company's products . Of these existing and potentia l 9 competitors, .a number have greater financial, marketing and technological resources than the Company . To date, 10 most of the Company's revenues have been derived fro m sales of products that operated under the MS-DOS 11 operating systems of Microsoft Corporation ("Microsoft") . One developer of a compatible operating system ha s 12 licensed a competitive data compression product for incorporation into the latest version of its operating 13 system . There can be no assurance that Microsoft o r personal computer manufacturers will not incorporate a 14 competitive data compression technology in their products or that such a technology will not otherwise emerge as an 15 industry standard . . . . Increased competition could result not only in a decline in sales volume but also in 16 price reductions that could have a material advers e effect on the Company's business, operating results and 17 financial condition .
18 This risk factor language was itself false and misleading because : 19 (a) Stac had learned that Microsoft had decided to 20 include data compression capability ("DoubleSpace") in its next 21 version of its MS-DOS operating system which Microsoft intended to 22 announce and introduce as soon as possible in 1992 ; 23 (b) Stac was taking action to delay Microsoft's 24 announcement that it had decided to include data compression 25 capability in its enhanced MS-DOS operating system to be introduced 26 as soon as possible in 1992 ; and 2 7
28
- 45 - 1 (c) Demand for Stac's main compression data products
2 (Stacker 2 .0) had weakened, in part due to the introduction of a
3 new and successful competitive product, and that in order to
4 stimulate sales of its products prior to the end of the March 31,
5 1992 quarter, Stac was granting special sales incentive terms
6 (including price discounts and rights of return) beyond those it
7 normally granted in the ordinary course of business .
8 59 . The Prospectus contained the following "Risk Factor"
9 language concerning Stac's Stacker product :
10 Dependence on Stacker . . Product Concentration . To date, most of the Company's . revenues have derived from 11 sales of its Stacker products . The Company introduced the initial version of its Stacker products in December 12 1990, followed by version 2 .0' in September 1991 . Sales of Stacker products have grown rapidly and represente d 13 $6,202,000 or 74% and $15,310,000 or 90% of the Company's revenues in fiscal 1991 and the first six months of 14 fiscal 1992, respectively . The Company expects tha t sales of these products will continue to be a substantial 15 malority of the Company's revenues . The Company does not yet have sufficient marketing history with respect to 16 Stacker products to predict whether the market for these products will continue to grow or at what rate . In 17 addition, the Company's Stacker products are designed for use with personal computers running MS-DOS or compatible 18 operating systems . Although the Company intends to develop and introduce products for other operatin g 19 systems, future sales of the Company's existing Stacker products are dependent upon continued use of the MS-DOS 20 operating system . The development of new operating systems or improvement of existing operating systems that 21 compete with MS-DOS and the market acceptance of such systems could adversely affect sales of the Company' s 22 products . . . . Thus, there can be no assurance that the Company will sustain its recent rate of revenue growth or 23 maintain profitability . Any overall decline in sales o f Stacker products could have a material adverse effect on 24 the Company's business, operating results and financial condition . 25 This risk factor language was false and misleading because : 26 (a) Stac had learned that Microsoft had already decided 27 to include (at no extra cost) data compression capability 28
- 46 - 1 ("DoubleSpace") in its next version of its MS-DOS operating system
2 which it intended to announce and introduce as soon as possible in
3 1992 ;
4 (b) Demand for Stac's main compression data products
5 (Stacker 2 .0) had weakened, in part due to the introduction of a
6 new and successful competitive product, and that in order to .
7 stimulate sales of its products prior to the end of the March 31,
8 199.2 quarter, Stac was granting special sales incentive terms
9 (including price discounts and rights of return) beyond those it
10 normally granted in the ordinary course of business ;
11 (c) in order to stimulate sales of its products at the
12 end of the quarter ended March 31, 1992, Stac was granting special
13 discount prices to selected customers which, combined with price
14 cuts which Stac anticipated making publicly, would trigger
15 substantial liability of Stac under the price protection agreements
16 it had with its customers ;
17 (d) . Stac had achieved strong revenue and net income
18 growth in its second quarter of fiscal 1992 ended March 31, 1992,
19 not because its Stacker 2 .0 data compression product had received
20 favorable publicity in trade publications and awards ; but rather,
21 due to the special price discounts and sales terms referred to
22, above ;
23 (e) Stac had "borrowed" sales from future periods in
24 order to artificially inflate sales of data compression products
25 prior to March 31, 1992, and Stac knew Microsoft would soon be
26 announcing and introducing an enhanced MS-DOS operating system
27 which included data compression capability and therefore Stac knew
28 that its revenues and net income would decline in future periods ;
- 47 - 1 (f) That because of the factors set forth above, Stac' s
2 business had peaked and entered a period of protracted decline ,
3 whereby the Company's profits and earnings per share would declin e
4 to levels well below those achieved in the recent past ;
5 (g) Stac's business had entered an extremely difficult
6 period characterized by increased competition and decreased sellin g
7 prices for Stac's products, such that Stac would suffer significan t
8 declines in its business ;
9 (h) Stac' s main product line -- data compressio n
10 products -- would soon be severely disadvantaged in the marketplace
11 by Microsoft's announcement and introduction of an improved MS-DOS
12 operating system that would include data compression capability at
13 no additional cost, thus ending,Stac's ability to achieve continued
14 profitable growth ; and
15 (i) Stac's profits had peaked during the first quarter
16 of calendar 1992 and because of the factors stated above, had
17 entered a period of protracted decline .
18 60 . The Prospectus contained the following "Risk Factor "
19 language concerning Stac's future results :
20 Quarterly Fluctuations . The Company has histori- cally experienced significant fluctuations in its opera- 21 ting results, including net income, and anticipates that these fluctuations will continue . The Company operates 2 2 with relatively little backlog, and the majority of its revenues in each quarter results from orders received in 23 that quarter . Consequently, if near-term demand for the Company's products weakens in a given quarter, the 24 Company's operating results for that quarter would be adversely affected . Quarterly . results have been and may 25 in the future be influenced, by distributor ordering patterns, the timing of announcements or introductions of 26 new products and product upgrades by the Company or competitors, product returns, delays in product develop- 27 ment, or licensing of the Company's core technology . During the first six months of fiscal 1992 the Company's 28 distributors and software reseller-returned substantia l
- 48 - 1 quantities of the initial version of Stacker in exchange for version 2 .0 of Stacker . Such returns did not 2 materially impact operating results for the first six months of fiscal 1992, however, as allowances for returns 3 of the initial version of Stacker had been established i n fiscal 1991 . Fluctuations could also be caused by 4 seasonal factors . As a result, the Company believes that period-to-period comparisons of its operating result s 5 should not be relied upon as an indication of future performance . 6
7 This risk factor language was false and misleading because :
8 (a) Stac had "borrowed" sales . from future periods in
9 order to artificially inflate sales of data compression products
10 prior to March 31, 1992, and because Stac knew Microsoft would soon
11 be announcing and introducing an enhanced MS-DOS operating system
12 which included data compression capability and that Stac knew that
13 its net income would decline (not fluctuate) in future periods ;
14 (b) That because of the factors set forth above, Stac's
15 business had peaked and was entering a period of protracted
16 decline, whereby the Company's profits and earnings per share would
17 decline well below the levels achieved in the recent past ;
18 (c) Stac's business had entered .an extremely difficult
29 period characterized by increased competition and decreased selling
20 prices for Stac's products, such that Stac would suffer significant
21 declines in its business ;
22 (d) Stac's main product line -- data compression
23 products -- would soon be severely disadvantaged in the marketplace
24 by Microsoft's announcement and introduction of an improved MS-DOS
25 operating system that would include data compression capability at
26 no additional cost, thus ending Stac's ability to achieve continued
27 profitable growth ; and
28
- 49 - 1 (e) Stac's profits had peaked during the first quarter
2 of calendar 1992 and because of the factors stated above, had
3 entered a period of protracted decline .
4 61 . After the Offering, Stac remained in constant contact
5 with Alex . Brown and Montgomery and worked with them to support
6 (inflate) the price of Stac stock in the aftermarket through the
7 issuance of false securities analysts' reports and other false
8 statements to the effect that Stac's business prospects and
9 financial condition were strong and that Stac would achiev e
10 substantially increased revenues and earnings in the fiscal years
11 to end September 30, 1992 and 1993, respectively .
12 62 . On June 2, 1992 -- just after the expiration of the SEC
13 mandated 25-day quiet-period following an initial public offering,
14 Alex . Brown issued a report on Stac which was widely circulated to
15 Alex . Brown brokers, customers and was publicly available . The
16 report stated :
17 Investment Conclusion : Strong Buy
18 We are initiating research coverage of Stac Electronics with an investment rating of "strong buy ." 19 STAC Electronics is the leading developer of data- compression software for personal computers . The 20 Company's Stacker 2 .0 product provides end-users with two hard-disk doubling solutions, software only and softwar e 21 plus silicon, both based on a patented data-compression algorithm . Stacker works seamlessly with other 22 applications and preserves data integrity . It is the Company's goal to make its technology the industry 23 standard for data compression .
24 We are setting earnings estimates as follows :
25 EPS Y/Y Change Revenue (mil .)
26 3Q 1992 $0 .15 NM $12 . 0 4Q 1992 $0 .18 NM $14 .5 27 FY 1992 $0 .55 NM $43 .5
28 1Q 1993 $0 .18 385 .0% $15 .5
- 50 - 1 2Q 1993 $0 .20 10 .4% $17 .5 3Q 1993 $0 .20 35 .3% $19 . 0 2 4Q 1993 $ 0 .24 35 . 2% $22 .5 FY 1993 $0 .82 49 .4% $74 .5 3 FY 1994 $1 .15 40 .4% $110 .0 4
5 We believe that the data-compression software market 6 will be a very attractive one . . . .
7
8 We believe that Stac Electronics is well -positioned to take advantage of this market opportunity . We esti- 9 mate that Stacker has a potential customer base of 40 million PC owners . In our opinion, . Stac Electronics is 10 the best -poised Company to exploit the data-compression market's opportunities because of the following . 11
12 • Protected, Proprietary Technology -- patents 13 protect key algorithms , adding to the difficulty of duplicating the Company ' s technology . 14
15 63 . On or about June 2 , 1992 , Montgomery also "initiated
16 coverage" of Stac by issuing an "aggressive buy" recommendation via
17 a research report which was widely circulated to Montgomery
18 brokers , customers and was publicly available . It stated :
19 We have initiated coverage of Stac Electronics (Stac ) with a rating of 1 (Aggressive Buy) because the 20 . company' s dominant position in the underpenetrated and rapidly growing market for data compression products and 21 strong development capabilities should enable it to emerge as one of the leading players in the compute r 22 software industry . Over the last five years Stac has evolved from a contract research and development shop to 23 a developer of error -correction and data compression chips for the tape drive market to the leading vendor of 24 data compression software for the PC . Since the release of the initial version of Stacker during the fall o f 25 1990, and the release of version 2 .0 in the fall of 1991, the company ' s product has won every major industry award 26 in the data compression software category and scored ver y favorably in product comparisons . In 1992 the company 27 plans to leverage its success in the DOS market into the OS/2 market . Although it is likely that powerful 28 competitors could enter this underpenetrated and rapidly
- 51 - 1 growing market, we believe that the company has the critical resources -- an established brand name, an 2 installed base of 300 000 . strong technical development capabilities , solid management and a recently enriched 3 balance sheet -- necessary to sustain its recent success .
4 The Montgomery report forecast fiscal 1992 and 1993 earnings per 5 share of $ . 52 and $ .74, respectively . 6 64 . The Alex . Brown and Montgomery reports issued on June 2, 7 1992 were false and misleading and the projections contained 8 therein lacked any reasonable basis and were not genuinely believed 9 by defendants because : 10 (a) Stac did not have the critical resources to sustain 11 its recent success because demand for its Stacker 2 .0 product had 12 weakened substantially and Microsoft was going to include data 13 compression capability in its next upgrade of its MS-DOS operating 14 system, which would decimate sales of Stac's data compression 15 products ; 16 (b) Stac did not have a dominant position in the market 17 for data compression products that would enable it to emerge as one 18 of the leading players in the computer software industry because 19 demand for its Stacker 2 .0 product had weakened substantially and 20 Microsoft was going to include data compression capability in its 21 next upgrade of its MS-DOS operating system, which would decimate 22 sales of Stac ' s data compression products ; 23 (c) Stac was not well-positioned to take advantage of 24 the opportunities in the data compression market because demand for 25 its Stacker 2 .0 product had weakened substantially and Microsoft 26 was going to include data compression capability in its next 2 7
28
- 52 - 1 1 upgrade of its MS-DOS operating system, which would decimate sales
2, of Stac's data compression products ;
3 (d) Stac was not the best poised company to exploit the
4. data compression market opportunities because demand for its
5 Stacker 2 .0 product had weakened substantially and Microsoft was
6 going to include data compression capability in its next upgrade of
7 its MS-DOS operating system, which would decimate sales of Stac's
8 data compression products ; and
9 (e) Stac's data compression algorithm was not really
10 proprietary and was not adequately protected by patents .
11 65 . The June 2, 1992 reports of Alex . Brown and Montgomery
12 were issued pursuant to an agreement between Stac, Stac insiders
13 and the Underwriters that the Underwriters would issue very
14 positive reports on Stac, including forecasts of future earnings
15 growth, . in return for being selected as the underwriters for the
16 public offering . Stac's top officers worked with Alex . Brown and
17 Montgomery to create the June 2 reports and provided the financial
18 forecast data for inclusion in those reports . The information
19 about Stac contained in those analysts' reports was obtained from
20 or based on information obtained from the Company . Copies or
21 drafts of those analysts' reports were provided to the Company
22 before they were released . Thus, the Company and its top officers
23 knew of the. contents of these reports, knew that they were based on
24 information provided by the Company and knew that they would be
25 publicly issued and affect the trading price of the Company's
26 stock, and thus they adopted those reports as their own .
27 66 . Responding to these favorable reports and positive
28 projections, inter alia , the price of .Stac stock climbed to a high
- 53 - 1 of $15-3/4 per share in early June 1992 . On July 1, 1992, just
2 after the close of - Stac's third quarter of fiscal 1992 and shortly
3 following an announcement by Quarterdeck Office Systems, another
4 computer software company, of poor third quarter results, the
5 market price of Stac stock unexpectedly fell . Defendant Clow
6 reassured the market by stating to the Dow Jones News Wire that
7 "there aren't any corporate developments at the company ," and that
8 the Quarterdeck announcement was the probable cause of Stac's price
9 decline . Montgomery and Alex .. .Brown analysts also stated to the
10 Dow Jones News Wire that Quarterdeck's problems did not signal
11 trouble for Stac . Montgomery stated that "Stac is a leader in an
12 emerging market . There's no similarity [with Quarterdeck) other
13 than the fact that Stac and Quarterdeck are both one- or two-
14 product (software) utility companies ." Alex . Brown stated that
15 Stac's compression software " continues to 'lust fly off the
16 shelves ." These statements were false and misleading because the
17 true facts, which were not disclosed, were :
18 (a) That in order to stimulate sales of its products at
19 the end of the quarter ended March 31, 1992, Stac had given special
20 discount prices to selected customers which, combined with price
21 cuts which Stac anticipated making publicly, would trigger
22 substantial liability of Stac under the price protection agreements
23 it had with its customers ;
24 (b) That Stac had achieved strong revenue and net income
25 growth in its second quarter of fiscal 1992 ended March 31, 1992,
26 not because its Stacker 2 :0 data compression product had received
27 favorable publicity in trade publications and awards ; but rather,
28
- 54 - 1 .due to special price discounts and rights of return different from
2 those it normally offered in the underlying course of business ;
3 (c) Because Stac had "borrowed" sales from future
4 periods in order to artificially inflate sales of data compression
5 products prior to March 31, 1992, and because Stac knew Microsoft
6 would soon be announcing and introducing an enhanced MS-DOS
7 . operating system which included data compression capability, Stac
8 knew that its revenues and net income would decline in future
9 periods ;
10 (d) By July 1, 1992, certain Stac customers had begun to
11 return products to Stac due to continued slowing sales of Stacker
12 2 .0, which was hurting Stac's .revenues and net income ; and
13 (e) By July 1, 1992, Stac sales were slowing .
14 -dramatically due to software demand for and increased return of
15 Stac's products, resulting in Stac's revenues and net income
16 falling from the March 31, 1992 quarter and being well below plan .
17 . 67 . On July 6, 1992, Montgomery issued a research report on
18 Stac which indicated that it believed Stac's third quarter sales
19 and earnings would not increase as much as earlier forecast .
20 However, the Montgomery analyst attributed this to "a general
21 slowdown in PC software sales," as opposed to any problem with Stac
22 and "says her earnings estimate reductions for Stac Electronics
23 shouldn't be interpreted by the financial community . . . as any
24 indication the company 'stuffed' its distribution channel in the
25 March quarter," as the March quarter sales "jump . . . reflects the
26 Company's shipment in the March 1992 quarter of .a new product that
27 received glowing trade press reviews ." These statements were false
28 and misleading, as the true facts, which were not disclosed, were :
55 1 (a) Demand for Stac's main compression data products
2 (Stacker 2 .0) had weakened, in part due to the introduction of a
3 new and successful competitive product, and that in order to
4 stimulate sales of those products, Stac was granting special sales
5 incentive terms including price discounts and rights of return
6 beyond those it normally granted in the ordinary course of
7 business ;
8 (b) That in order to inflate the revenues and net income
9 Stac reported for the quarter and the six months ended March 31,
10 1992, Stac had induced certain of its customers to order extra
11 merchandise on special consignment terms, which it did not grant in
12 the ordinary course of business, and which were not bona fide
13 sales ;
14 (c) That in order to stimulate sales of its products at
15 the end of the quarter ended March 31, 1992, Stac was offering
16 special . discount prices .to selected customers which, combined with
17 price cuts which Stac anticipated making publicly, would trigger
18 substantial liability of Stac under the price protection agreements
19 it had with its customers ;
20 (d) That Stac had achieved strong revenue and net income,
21 growth in its second quarter of fiscal 1992 ended March 31, 1992,
22 not because its Stacker 2 .0 data compression product had received
23 favorable publicity in trade publications and awards ; but . rather,.
24 due to the special price discounts and sales terms referred to
25 above ;
26 (e) Because . Stac had "borrowed" sales from future
27 periods in order to artificially inflate sales of data compression
28 products prior to March 31, 1992, and because Stac knew Microsoft
- 56 - 1 would soon be announcing and introducing an enhanced MS-DOS
2 operating system which included data compression capability, Stac
3 knew that its revenues and net income would decline in future
4 periods ;
5 (f) By July 1, 1992, certain Stac customers had begun to
6 return products to Stac due to continued slowing sales of Stacker
7 2 .0, which was hurting Stac's revenues and net income ; and
8 (g) By July 1, 1992, Stac sales were slowing
9 dramatically due to software demand for and increased return of
10 Stac's products, resulting in Stac's revenues and net income
11 falling from the March 31, 1992 quarter and being well below plan .
12 68 . The next day, on July 7, 1992, Alex . Brown issued a
13 report on Stac which maintained its positive 1992 and 1993 earnings
14 estimates of $ .55 and $ .82 per share, respectively . The Alex .
15 Brown report stated :
16 As many software companies are pre-announcing disappointing June quarter results, fears are growing 17 among investors that factors influencing some softwar e vendors will uniformly impact all vendors . We do not 18 believe that this is the case for Stac Electronics and we maintain our "'strong buy" rating and current estimates . 1 9
20 The information about Stac contained in this report was obtained
21 from or based on information obtained from Stac and its top
22 officers and copies of drafts of this report were provided . to . Stac
23 and its top officers before it was released ; thus Stac knew of the
24 report, its contents, that it was based on information provided by
25 Stac, and that it would be issued to members of the investing
26 public, be circulated throughout the investment community and
27 impact the trading price of Stac common stock and thus adopted the
28 report as their own . The statements in this report were false and
- 57 - 1 misleading and the projections contained therein lacked any
2 reasonable basis and were not genuinely believed by the defendants .
3 The true facts, which were not disclosed, were :
4 (a) That in order to stimulate sales of its products at
5 the end of the quarter ended March 31, 1992, Stac was operating
6 special discount prices to selected customers which, combined with
7 price cuts which Stac anticipated making publicly, would trigger
8 substantial liability of Stac under the price protection agreements
9 it had with its customers ;
10 (b) That Stac had achieved strong revenue and net income
11 growth in its second quarter of fiscal 1992 ended March 31, 1992,
12 not because its Stacker 2 .0 data compression product had received
13 favorable publicity in trade publications and awards ; but rather,
14 due to the special price discounts and sales terms referred to
15 above ;
16 (c) Because Stac had "borrowed" sales from future
17 periods in order to artificially inflate sales of data compression
18 products prior to March 31, 1992, and because Stac knew Microsoft
19 would soon be announcing and introducing an enhanced MS-DOS
20 operating system which included data compression capability, Stac
21 knew that its revenues and net income would decline in future
22 periods ; and
23 (d) That because of the factors set forth above, Stac's
24 business had peaked and was entering a period of protracted
25 decline, whereby the Company's profits and earnings per share would
26 decline to levels well below those achieved in the recent past .
27 69 . Contrary to these false statements and assurances, only
28 two weeks later, on July 20, 1992, Stac suddenly revealed tha t
- 58 - 1 sales of Stacker products had fallen in the . third quarter ended
2 June 30, 1992, declining from the second quarter .ended March 31,
3 1992 . Stac's revenues for the quarter were $10 million, compared
4 to $11 .6 million in the prior quarter, while net income was'only
5 $2 .76 million, compared to $4 .21 million in the prior quarter or
6 $ .11 per share, compared to $ .17 and that its sales and net income
7 would continue to decrease in the next quarter . Stac's net income
8 decline was due, in part, to inventory writedowns for returned Stac
9 products that had been sold prior to the end of the March 3, 199 2
10 quarter with special rights of return . Thus, Stac was required in
11 its third quarter of fiscal 1992 to write down what it had falsely
12 represented were and were reported as sales and profits in the
13 quarter immediately prior to the offering, and to take writedowns
14 reflecting, inter alia , what should have been reserved in that
15 prior quarter . In response to these revelations, the market price
16 of Stac common stock, which had climbed to over $15 following the
17 Offering, plummeted to $5 .50 per share and continued to decline to
18 just $3 per share by September 1992 and ultimately as low as $1-3/4'
19 per share .
20 70 . Stac's business has continued to decline, reflecting the
21 poor sales of its Stacker 2 .0 product due to the success of
22 competitive products and Microsoft's announcement of its enhanced
23 MS-DOS 6 .0 operating system which contained data compression
24 capabilities ("DoubleSpace"), which has decimated the market for
25 Stac's data compression products . On October 29, 1992, the Company
26 . announced that its fourth quarter revenue had declined to
27 $6,245,000, its net income fell to $526,000 and its earnings per
28 share to just $ .02, again due to declining sales of Stacker 2 .0 .
- 59 - 1 in this quarter, Stac continued to suffer impaired earnings as it
2 incurred special charges due to the continued return of product
3 sold with special rights of return prior to March 31, 1992, and due
4 to price protection obligations incurred due to price cuts it was
5 making to try to stimulate sales of its products . During fiscal
6 1992 (October 1, 1991-September 30, 1992), Stac continued to report
7 poor results well below those achieved in the period ending March
8 31, 1992 and ultimately laid off 20% of its employees and
9 contracted the size of its business due to declining sales o f
10 Stacker . After suffering losses in the third and fourth quarters
11 of fiscal 1993, Stac managed to earn just $ .02 per share for all of
12 fiscal 1993 . The full extent of the terrible decline in Stac's
13 business since the public offering is shown by the following chart :
14 Quarter Ended (All amounts in thousands, except EPS) 15 12/31/91 3/31/92 6/30/92 9/30/92 12/31/92 3/31/93 6/30/93 9/30/93 16 Revenue $5,393 $11,664 $10,000 $ 6,200 $12,300 $11,000 $ 5,700 $ 7,700 17 Net Income 857 4,200 2,700 526 2,100 1,000 (2,300) (420) 18 Earnings 19 Per Share N/A .17 .11 .02 .08 .04 ( .10) ( .02)
20 71 . The information concealed by defendants is 'the type of 21 information which is material to investors and the securities 22 markets : 23 (a) In addition to the periodic reports required under 24 the Exchange Act, management of a public company has a duty 25 promptly "to make full and prompt announcement of material facts 26 regarding the company's financial condition ." Release No . 34-8995 27 (Oct . 15, 1970), 17 C .F .R . §241 .8995 . The SEC has repeatedly 28
- 60 - 1 -stated that the provisions of the federal securities laws, which
2 are intended to ensure. that the investing public is provided with
3 "complete and accurate information about companies whose securities
4 are publicly traded," apply to all public statements by persons
5 speaking on behalf of publicly traded companies "that can
6 reasonably be expected to reach investors and the trading markets,
7 whoever the intended audience ." Release No . 33-6504 (January 13,
8 1984), 17 C .F .R . S241 .20560 . The SEC has emphasized that
9 "investors have legitimate expectations that public companies ar e
10 making and will continue to . make prompt disclosure of significant
11 corporate developments ." Release No . 18271 (November 19, 1981)
12 (1981-1982 Transfer Binder] Fed . Sec . L . Rep . (CCH) 183,049 ;
13 (b) Schedule D of the National Association of securities
14 Dealers ("NASD") Manual which governs companies whose securities
15 are included in the NASDAQ National Market System, requires a
16 NASDAQ company to "make prompt disclosure to the public through the
17 press of any material information that may affect the value of its
18 securities or influence investors' decisions ." NASD Manual,
19 Schedule D, Part II, §l(c)(13) [11803 (c)(13)] ;
20 (c) The New York Stock Exchange ("NYSE") Manual provides
21 that a public company listed on the NYSE "is expected to release
22 quickly to the public any news or information which might reason-
23 ably be expected to materially affect the market . for its securi-
24 ties . This is one of-the most important and fundamental purposes
25 of the listing agreement which the company enters into with the
26 Exchange ." NYSE Manual §202 .05 ; and
27 (d) The American Stock Exchange ("AMEX") Guide,
28 governing securities listed on the AMEX, provides "the conduct of
61 - 1 a fair and orderly market requires every listed company to make
2 available to the public information necessary for informed
3 investing and to take reasonable steps to ensure that all who
4 invest in its securities enjoy equal access to such information ."
5 AMEX Guide §401 .
6 72 . While the false and misleading prospectus was in effect,
7 the Individual Defendants sold 538,000 shares of Stac stock they
8 owned for proceeds of $6,456,000 to profit from the artificial
9 inflation in the Stac stock price their fraud created .
10 Notwithstanding their access to confidential information as a
11 result of their status as directors and/or officers of the Company
12 and their corresponding duty to disclose the adverse material facts
13 set forth herein, the Individual Defendants sold or otherwise
14 disposed of significant amounts" of Stac shares at artificially
15 inflated prices throughout the Class Period . Of the 3 million
16 shares offered in the May 7, 1992 public offering, 1 .5 million
17 shares were sold by insiders, including certain Individual
18 Defendants as follows :
19 Officer, Director Shares Sold in Offering Proceeds
20 Gary W . Clow 200,000 $2,400,000
21 Douglas L . Whiting 200,000 $2,400,000
22 Robert W . Johnson 100,000 $1,200,000
23 Arthur J . Collmeyer 8,000 $ 96,000
24 John R . Witzel 30,000 $ 360,000
25 538,000 6,456,000
26 STAC'S FALSE FINANCIAL STATEMENT S
27 73 . In order to report substantially increased revenues and
28 earnings to inflate the price of its stock in the public offering,
- 62 - 1 Stac and its insiders manipulated Stac's reported revenues and
2 earnings for the period ended March 31, 1992, through improper
3 practices in violation of Generally Accepted Accounting Principles
4 ("GAAP") . As a result of these improper practices, Stac's
5 financial statements for the first six months of fiscal 1992, ended
6 March 31, 1992, did not fairly present Stac's financial condition
7 and results from operations, in conformity with GAAP . In fact,
8 those results were materially false and misleading in that
9 revenues, net income, net income per share, and retained earnings
10 as reported were improperly and materially inflated .
11 74 . Financial Accounting Standards Bulletin ("FASB") 48,
12 paragraph 7 states : "Sales revenue and cost of sales reported in .
13 the income statement shall be reduced to reflect estimated
14 returns ." Because it created extra "sales" of March 31, 1992 by
15 extending special rights of return to customers, Stac knew that
16 significant amounts of Stacker product would be returned . Stacl
17 also knew that its reserves for returns was not accurate or
18 adequate and had not resulted in the creation of adequate reserves .
19 Nevertheless, Stac made no material change in the manner in which
20 reserves were created and computed because to do so would have
21 reduced the revenue and net income growth Stac's insiders wanted
22 Stac to report at March 31, 1992 and impaired its image as a
23 company on a rapid growth track . In addition, during the quarter
24 ended March 31, 1992, Stac improperly recognized revenue by
25 recording as sales, shipments of Stacker 2 .0 that were not bona
26 fide sales, but rather, consignments whereby the customers had the
27 ability to return the product if it was not sold . Finally, Stac
28 failed to record adequate liabilities for its price protection
- 63 - 1 obligations to its customers at March 31, 1992, which it knew
2 existed as of that date .
3 75 . As a result of the improper and misleading accounting
4 practices set forth above, Stac's March 31, 1992 financial
5 statements, which were publicly disseminated during the Class
6 Period were materially false and misleading in that they were not
7 prepared in accordance with GAAP, and the quarterly financial
8 statements were not prepared pursuant to the rules and regulations
9 of the SEC or in accordance with GAAP . As a result, these
10 financial statements did not reflect all adjustments necessary to
11 present fairly the financial position, results of operations and
12 changes in the financial position of Stac's revenues and net
13 earnings, which were overstated, in material amounts for the periods
14 presented .
15 CLAIM FOR RELIEF I
16 Against All Individual Defendants, The Underwriters and The Venture Capital Defendants 17 For Violations of §11 of the Securities Ac t
18 76 . Plaintiffs incorporate by reference 1[1[1-75 except allega-
19 tions of fraud . This Count is asserted against Stac and all
20 defendants who signed or controlled a person who signed the Regis-
21 tration Statement for Stac's May 7, .1992 Offering and the
22 underwriters of the May 7, 1992 Offering .
23 77 . Defendants are signatories of the Registration Statement
24 and/or controlling persons of the issuer, Stac, or Underwriters of
25 the Registration Statement . They owed purchasers of the stock the
26 duty to make a reasonable investigation of the statements contained
27 in the Registration Statement and Prospectus to ensure that said
28 statements were true and that there was no omission to state any
- 64 - 1 material fact required to be stated in order to make the statements
2 contained therein not misleading . Defendants knew or, in the
3 exercise of reasonable care, should have known of the material
4 misstatements and omissions contained in the Registration Statement
5 and Prospectus as set forth herein . None of the defendants made a
6 reasonable investigation or possessed reasonable grounds for the
7 belief that statements contained in the Registration Statement *and
8 Prospectus were true or that there was not any omission of material
9 fact necessary to make the statements made therein not misleading .
10 78 . By reason of the conduct . . herein . alleged, each defendant
11 violated, and/or controlled a person who violated, §11 of the
12 Securities Act to the damage of plaintiffs and the Class .
13 79 . This action was brought within one year after the revela-
14 tions of July 20, 1992, which led to the discovery of the untrue
15 statements and omissions and within three years after Stac stock
16 was offered to the public .
17 CLAIM FOR RELIEF I I
18 Against All Individual Defendants and The Venture Capital Defendants For Violation 19 of §15 of The Securities Ac t
20 80 . Plaintiffs incorporate ¶[1[1-79 as if set forth fully
21 herein .
22 81 . The defendants named in this Claim for Relief acted as
23 controlling persons of the Company within the meaning of §15 of the
24 Securities Act . By reason of their senior management positions
25 and/or directorships or stock ownership, as alleged above, these
26 defendants had the power to influence and exercised the same to
27 cause Stac to-engage in the unlawful acts and conduct complained of
28 herein . The Venture Capital firm defendants-each controlled their
- 65 - 1 respective representative on Stac's Board and had the power to
2 influence and exercised the 'same . to cause Stac to engage in the
3 unlawful acts and conduct complained of herein .
4 82 . By reason of such control, the defendants named in this
5 Claim for Relief are . liable pursuant to §15 of the Securities Act .
6 As a direct and proximate result of these defendants' wrongful
7 conduct, plaintiffs and the other members of the Class suffered
8 damages in connection with their purchases of the Company's common
9 stock during the Class Period .
10 CLAIM FOR RELIEF II I
11 Against All Defendants For Violations of §10(b) Of The Exchange Ac t 12 And SEC Rule 10b- 5
13 83 . Plaintiffs incorporate 11[1-82 . This Count is asserted
14 against all defendants .
15 84 . The following conspiracy, aiding and abetting and
16 concerted action allegations, 1184-90 are made on information and
17 belief, based upon the existence of the material adverse facts
18 alleged in 1[1[44, 49, 51, 53, 55, 58-60, 64, 66-68, 73-75 hereof ;
19 the defendants' access to and knowledge, of those facts ; each
20 defendants' failure to disclose the material adverse facts-alleged
21 in ¶1[44 ., 49, 51, 53, 55, 58-60, 64, 66-68, 73-75, despite their
22 knowledge of those facts ; the benefits gained by the defendants in
23 conducting . the fraud alleged herein (as discussed in, inter alia ,
24 1572 hereof) ; the Individual Defendants' positions as executive
25 officers and/or directors of Stac ; and meetings of Stac directors
26 and officers at which the directors and officers discussed the
27 business and affairs of Stac . In committing the wrongful acts
28 alleged herein, all of the defendants have pursued a common course
- 66 - 1 of conduct and acted in concert with and conspired with' one
.2 another, in furtherance of their common plan, scheme or design . In
3 addition to the wrongful conduct herein alleged as giving rise to
4 primary liability, defendants further aided and abetted and
5 knowingly assisted each other in breach of their respective duties
6 as herein alleged .
7 85 . During all relevant times hereto, defendants, and each of
8 them, initiated -and/or joined in the course of conduct which was
9 designed - to and did (i) deceive theinvesting public, includin g
10 plaintiffs and other class members regarding Stac's products,
11 markets, demand for its products, finances, financial condition and
12 present and future business prospects ; (ii) artificially inflate
13 the market price of Stac common stock during the class Period ;
14 (iii) cause plaintiffs and other members of the Class to purchase
15 or otherwise acquire Stac common stock at inflated prices ; and
16 (iv) permit certain defendants to sell large amounts of their Stac
17 common stock at inflated prices . In furtherance of this plan,
18 conspiracy and course of conduct, defendants, and each of them,
19 took the actions as herein set forth .
20 86 . Defendants engaged in a conspiracy, common enterprise or
21 common course of conduct, commencing at least by March 1992, in
22 violation of the federal securities law for the purpose and effect
23 of which was, inter alia , to optimistically and falsely present the
24 Company's financial condition and future business prospects . The
25 defendants engaged in such a scheme so that they . could inflate the
26 price of the Company's common stock in order to : (i) protect and
27 enhance their executive positions and the substantial compensation
28 and prestige they had obtained thereby ; (ii) enhance the value of
- 67 - 1 their personal Stac securities holdings and options ; (iii) sell
2 shares of Stac common stock they owned at inflated prices to obtain
3 large amounts of cash and large profits and/or avoid significant
4 'losses ; (iv) inflate the reported profits of the Company in order
5 to obtain large payments under Stac's incentive bonus compensation
6 plan and/or via discretion in the individual performance bonuses .
7 (a) All of the defendants engaged in a conspiracy,
8 common enterprise or common course of conduct commencing in March
9 of 1992, the purpose and effect of which was, inter alia , to
10 prolong the illusion of Stac's continued growth and to make it
11 appear that Stac's Stacker 2 .0 was very successful and thereby
12 artificially inflating the price of Stac's common stock in
13 violation of the anti-fraud provisions of the federal securities
14 laws . Defendants accomplished their conspiracy, common enterprise
15' or common course of conduct of artificially inflating the price of
16 Stac common stock through the issuance of a misleading Prospectus
17 and Registration Statement and a series of interrelated and
18 interdependent false reports and press releases to the public,
19 which misrepresented and failed to disclose the true facts
20 regarding Stac's products, markets and present and future business
21 prospects and created a false impression of continuing growth and
22 record profitability .
23 (b) In addition, certain of the Individual Defendants
24 all benefitted from the illegal course of conduct by selling Stac
25 stock owned by them at artificially inflated prices without
26 disclosing the material, adverse and non-public facts about Stac to
27 which they were privy, despite their duty to disclose all material
28 adverse facts or refrain from selling Stac stock . Each defendant
- 68 - 1 was a direct, common, necessary and substantial participant in the
2 conspiracy, common enterprise or common course of conduct
3 complained of herein .
4 87 . Each of the named defendants herein aided and abetted and
5 rendered substantial assistance in the wrongs complained of herein .
6 In taking the actions, as particularized herein, to substantially
7 assist the commission of the fraud complained of, each defendant
8 acted with knowledge of the primary wrongdoing, substantially
9 assisted the accomplishment of that fraud, and was aware of hi s
10 overall contribution to and furtherance of the fraud . Defendants'
11 acts of aiding and abetting include, inter alia , the acts, they are
12 alleged to'have committed in furtherance of the conspiracy, common
13 enterprise, and common course of conduct complained of herein,
14 except those relating to the reaching of agreements or under-
15 standings sufficient to categorize their conduct as conspiratorial .
16 88 . Each of the defendants either knew or recklessly
17 disregarded the fact that the illegal acts and practices and
18 misleading statements and omissions described herein would
19 adversely affect the integrity of the market for Stac's common
20 stock and would artificially maintain the prices of those
21 securities . Each of the defendants, . by acting as herein described,
22 did so knowingly or in such a reckless or grossly negligent manner
23 as to constitute a fraud and deceit upon plaintiffs and members of
24 the Class plaintiffs seek to represent .
25 89 . The foregoing statements of defendants misrepresented the
26 true financial and operating condition and future prospects of Stac
27 and failed to disclose material facts necessary to make the
28 statements made, in the context in which they were made, not
- 69 - 1 misleading, in violation of S10(b) of the Exchange Act and SEC Rule
2 10b-5 . These reports made untrue statements of material facts and
3 omitted to state material facts necessary in order to make the
4 statements made, in light of the circumstances under which they
5 were made, not .misleading . The defendants are also liable under
6 §10(b) and Rule lOb-5 as controlling persons pursuant to §20(a) of
7 the Exchange Act .
8 90 . During the Class Period, the defendants, individually and
9 in concert, directly and indirectly, engaged and participated in or
10 aided and abetted a continuous course of conduct to conceal adverse
11 material information regarding Stac . Defendants employed devices,
12 schemes, and artifices to defraud and engaged in acts, practices, .
13 and a course of conduct as hereinafter alleged in an effort to
14 maintain artificially high market prices for Stac stock . This
15 included the formulation, making of and/or participation in thel
.16 making of untrue statements of material facts and omitting to state
17 material facts necessary in order to make the statements made, in
18 light of the circumstances under which they were made, not
19 misleading, and engaging in acts, practices and courses of business
20 which operated as a fraud and deceit upon members of the Class .
21 91 . Each of the defendants, by acting as hereinabove
22 described, did so knowingly or in such a reckless manner as to
23 constitute a fraud upon the Class . With knowledge or reckless
24 disregard of the true financial and operating condition of Stac,
25 the defendants caused the reports, statements and releases to
26 contain misstatements and omissions of material fact as alleged
27 herein .
28
- 70 - 1 92 . In ignorance of the adverse facts and relying upon the
2 integrity of the market in Stac' .s stock, plaintiffs and the members
3 of the Class acquired the Company's stock at artificially inflated
4 prices and were damaged thereby .
5 93 . Had plaintiffs and the members of the Class known of the
6 materially adverse information which was not disclosed by defen-
7 dants, they would not have purchased the company's stock at . all or,
8 if so, not at the artificially inflated prices they did and
9 sustained damages thereby . . ,
10 CLAIM FOR RELIEF I V
11 Against All Individual Defendants and The Venture Capital Defendants For Violation 12 of §20(a) of The Exchange Ac t
13 94 . Plaintiffs incorporate 111-93 as if set forth fully
14 herein .
15 95 . The defendants named in this Claim for Relief acted as
16 controlling persons of the Company within the meaning of §20(a) of
17 the Exchange Act . By reason of their positions as senior officers
18 and/or directors or stockholders as alleged above, these defendants
19 had'the power and authority to cause the company to engage in the
20 wrongful conduct complained of herein . The Venture -Capital
21 Defendants each controlled their respective representative on
22 Stac's Board and had the power to influence and exercised the same
23 to cause Stac to engage in the unlawful acts and conduct complained
24 of herein .
25 96 . By reason of such wrongful conduct, defendants are liable
26 pursuant to §20(a) of the Exchange Act . As a direct and proximate
27 result of the defendants' wrongful conduct, plaintiffs and the
28 other members of the Class suffered damages in connection with
- 71 - 1 their purchases of the Company'-s common stock during the Class
2 Period .
3 PRAYER FOR RELIE F
4 WHEREFORE, plaintiffs pray for judgment :
5 1 . Declaring this action to be a proper class action
6 pursuant to Rule 23(a) and 23(b)(3) of the Federal Rules of Civil
7 Procedure on behalf of the Class defined herein ;
8 2 . Awarding plaintiffs and the members of the Class compen-
9 satory damages ;
10 3 . Awarding plaintiffs and the members of the Class, pre-
11 judgment and post-judgment interest, as well as their reasonable
12 attorneys' fees, expert witness fees .and other costs and expenses
13 for this litigation ;
14 4 . Extraordinary equitable and/or injunctive relief as
15 permitted by law, equity and federal and state statutory provision
16 sued hereunder, including attaching, impounding, imposing a con-
17 structive trust upon or otherwise restricting the proceeds of
18 defendants' trading activities or their other assets so as to
19 assure that plaintiffs and the Class have an effective remedy ; and
2 0
21
22
23
24
25
26
27
28
72 1 5 . Awarding such other relief as this Court may deem jus t
2 and proper .
3 JURY DEMAND
4 Plaintiffs demand a trial by jury .
5 DATED : November , 199 3 MILBERG WEISS BERSHAD 6 . HYNES & LERACH WILLIAM S . LERACH 7 LEONARD B . SIMON THEODORE J . PINTAR 8
9
f i 10 WILLIAM S . LERACH 11 600 West Broadway, Suite 180 0 12 San Diego, CA 9210 1 Telephone : 619/231-105 8 13 LAW OFFICES OF JOSEPH H . 14 WEISS JOSEPH H . WEISS 15 DAVID C . KAT Z 319 Fifth Avenu e 16 New York, NY 10016 Telephone : 212/532-417 1 17 LAW OFFICES OF JOSEPH H . 18 WEISS KEVIN J . YOURMAN 19 1800 Avenue of the Star s Suite 100 0 20 Los Angeles, CA 90067 ' Telephone : 310/277-157 4 21 Co-Lead Counsel for Plaintiff s 2 2
2 3
2 4
2 5
2 6
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28
STACUKL00739 .CPT - 73 - 1 DECLARATION OF SERVICE BY MAIL
2
3 I, the undersigned, declare :
4 1 . That declarant is and was, at all times herein mentioned,
5 a citizen of the United States and a resident of the County of San
6 Diego, over the age of eighteen (18) years, and not a party to or
7 interested in the within action ; that declarant's business address
8 is 600 West Broadway, Suite 1800, San Diego, California 92101 .
9 2 . That on November 18, 1993, declarant served the FIRST
10 AMENDED CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATION OF THE
11 FEDERAL SECURITIES LAWS by depositing a true copy thereof in a
12 United States mailbox at San Diego, California in a sealed envelope
13 with postage thereon fully prepaid and addressed . to the parties
14 listed-on the attached Service List .
15 3 . That there is a regular communication by mail between the
16 place of mailing and the places so addressed .
17 I declare under penalty of perjury that the foregoing is true
18 and correct . Executed this 18th day of November, 1993, at San
19 Diego, California .
20 Lav, K.-/`_ 21 PILAR COLINA
2 2
23
24
25
26
27
28 EXHIBIT B 0 ORIGINAL .! MILBERG WEISS BERSHAD HYNES & LERACH LLP WILLIAM S. LERACH (68581) ? .NitY ! 4 JAN M. ADLER (105266 ) TOR GRONBORG (179109) qtr sf ri rk z, P r (`sir n C i r J. KAREN A. BATCHER (190810) .1F0 fry"Fr 401 B Street, Suite 170 0 San Diego, CA 92101 Telephone: 619/231-1058 U r y Lead Counsel for Plaintiffs
UNITED STATES DISTRICT COURT
10 SOUTHERN DISTRICT OF CALIFORNIA
11 In re DAOU SYSTEMS, INC. SECURITIES ) Master File Nair 12 LITIGATION } 98cv1537-LGA)
13 CLASS ACTION This Document Relates To : 14 } THIRD AMENDED CLASS ACTION ALL ACTIONS . ) COMPLAINT FOR VIOLATION OF THE 15 FEDERAL SECURITIES LAWS
16 DEMAND FOR JURY TRIAL
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1 SUMMARY OF THE ACTION 2 1 . This action is brought on behalf of a class of purchasers of Daou Systems, Inc.
3 ("Daou" or the "Company") . common stock between February 13, 1997 and October 28, 1998, 4 inclusive (the "Class Period"), seeking damages resulting from a fraudulent scheme and course of 5 business by defendants, which harmed purchasers ofDaou stock during the Class Period . Defendants 6 are the Company, its Chief Executive Officer and Chairman Georges Daou ("G . Daou"), President 7 and Director Daniel Daou ("D . Daou"), Chief Financial Officer and Senior Vice President Fred 8 McGee ("McGee"), Chief Operating Officer and Executive Vice President Robert McNeill
9 ("McNeill") and Director John Moragne ("Moragne") . Over the course of 20 months, beginning with 10 Daou's initial public offering, each of these defendants issued false and misleading statements about 11 Daou's accounting practices, revenue, earnings and business condition that, collectively, artificially 12 inflated Daou's stock price to all-time high prices above $34 per share . In rapid succession, 13 defendants sold $30 .5 million of their personal stock holdings, the defendants' friends and families 14 dumped an additional $24 .2 million in Daou stock and defendants used $137 .7 million worth of 15 artificially inflated Daou securities for a corporate acquisition spending spree, all of which occurred
16 while defendants knew that the Company's financial and business results were being misrepresented 17 to the investing public . 18 2. Before its collapse, Daou designed, implemented, supported and managed computer 19 network systems primarily for hospitals, integrated healthcare delivery networks and other healthcare 20 provider organizations . Throughout the Class Period, Daou held itself out as a rapidly expanding, 21 technologically astute, computer system design and support company, focused on the rapidly
22 changing medical field. For seven consecutive quarters, defendants reported that Daou had "record" 23 growing revenues and that the Company's earnings per share ("EPS") had and would exceed market 24 expectations published by securities analysts. Daou's self-professed "spectacular" results and "strong 25 revenue and earnings growth" were coupled with public statements about Daou's successful employee 26 retention and training and the benefits ofthe Company's "extremely strong pipeline position ." These 27 statements drove Daou's stock price up to an all-time high of $34.375 per share by September 1997 . 28 All of these statements, however, were false and misleading when made .
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1 3 . Between 1Q97 and 2Q98, defendants recognized and publicly reported at least
2 $18.6 million in revenue, more than 22% of Daou's total reported revenue, in violation of Generally
3 Accepted Accounting Principles ("GAAP") and Daou's own stated accounting policy . Under the
4 percentage of completion ("POC") accounting methodology defendants purported to follow, revenue
5 from Daou's long-term network system contracts could only be recognized based on the percentage
6 of labor costs incurred to date compared to total estimated labor costs for the project. Under GAAP,
7 defendants could not arbitrarily determine what percent of a project was complete, but were required
8 to recognize revenue in line with a reasonable and defensible degree of accuracy based on a
9 comprehensive review of each contract . In fact, defendants recognized millions of dollars in revenue
10 before it was earned and without regard to actual labor costs incurred or total estimated labor costs .
11 4. The first-hand accounts of28 formerDaou employees and customers demonstratethat
12 the publicly reported revenue for 4Q96-2Q98 was artificially inflated by defendants' violations of
13 Daou's accounting policy and GAAP. On contracts from Centura Health (Colorado) to Mercy Health
14 Services (Iowa), defendants G . Daou, D. Daou, McGee and McNeill would immediately book 20%
15 of the total contract value as revenue upon contract signing, whether or not any labor had yet been
16 expended in the performance of the contract . On a $5 million contract, for example, defendants were
17 booking $1 million in revenue immediately, even though both GAAP and Daou's stated policy
18 required that the revenue not be booked until Daou had incurred 20% of the total estimated labor
19 costs for the project. Indeed, in at least one case, Candler Health Systems (Georgia), Daou
20 recognized revenue in the final days of 3Q97 on a contract that was not even signed and, in the end,
21 would never be executed. Defendants systematically, without regard to labor costs incurred or
22 estimated, recognized 40% of the revenue from Daou's contracts immediately after the equipment to
23 be installed was ordered and 50%-60% of the revenue as soon as the equipment was configured and
24 tested. While the vast majority of labor costs were incurred after the equipment was sent to the
25 customer for on-site installation and testing, the majority of revenue under defendants' scheme was
26 recognized before substantial labor costs were incurred . In 2Q97 alone, 30%-40% of the revenue
27 from Daou's Centura Health contract was "recognized after Field Services employees had done
28 nothing more than unpack and plug-in computers destined for the project. To create the appearance
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I of actual labor costs incurred, defendants directed several Field Services employees to show up at
2 Daou's San Diego facilities on the last Saturday in June 1997, plug in the Centura Health computers
3 and claim eight hours of work each . In return, the salaried employees were offered $100 each . Not
4 surprisingly, the employees were later told to forget about the incident, i.e.,to "forget it ever
5 happened."
6 5. Even after equipment was actually shipped, defendants continued to recognize revenue 7 in advance of what was allowed under Daou's accounting policy and GAAP . At the beginning of a 8 project, Daou would "estimate" the labor hours needed to complete it on an ad hoc basis, without 9 considering the customer's facilities or equipment . The formula used to estimate labor hours became
10 a joke among project engineers because it was grossly understated 99% of the time . The estimates 11 of on-site project managers who knew exactly what work needed to be done and how long it would 12 take were dramatically reduced by defendants without explanation . By underestimating the labor 13 hours needed, the project would show a higher percentage of completion than if accurate figures were 14 used. Daou would then record more revenue, even when it was unable to bill the customer for that
15 amount. Defendants knew the labor estimates were incorrect because Daou kept track of actual labor 16 hours worked versus hours estimated through employee job costing sheets compiled into the 17 comprehensive Monthly Project Report. As a result of defendants' use of inaccurate and 18 unreasonably low total estimated labor costs, defendants recognized revenue before it was earned, 19 reporting revenue on contracts as if they were 100% completed, when, in fact, substantial work
20 costing millions of dollars remained . On one occasion in early January 1998, an employee was 21 specifically told she could no longer bill to a project because it was "closed" for billing purposes . But, 22 the project was only slightly more than two-thirds completed . A larger proportion of the project had 23 been billed and recorded as revenue in FY97 to increase earnings than was permitted in accordance 24 with the true percent of labor completed.
25 6. Defendants' statements about Daou's employees and business pipeline were equally
26 false and misleading. While investors and the market were told that Daou was successfully retaining
27 employees and turnover was only 6 .8%, turnover actually exceeded 40% and the engineers needed
28 to implement the Company's network systems were leaving Daou in droves . Defendants'
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1 representations regarding Daou 's state-of-the-art training and the bene fits of "Daou University" had
2 no basis in fact. Daou had no formal training, was sending unqualified personnel , including auto
3 mechanics and cable pullers who could not operate the most simple computer programs, into the field 4 as PC technicians and senior engineers and Daou University did not exist and was instead a complete
5 fiction. Daou's "pipeline" figures, publicly provided on a quarterly basis to demonstrate that Daou's .6 business was continuing to expand, were equally fictitious. The "pipeline" was primarily composed 7 of projected revenue on contracts for which Daou had merely made a bid or met with a customer,
8 even when the odds of Daou getting the project were slim . Again, defendants' publicly disseminated 9 financial information had no reasonable basis and were intended only to boost Daou 's stock price.
10 7. All ofthese false and misleading statements had their desired effect, a rtificially inflating 11 and maintaining the inflation in Daou's stock price. The following graph shows the price of Daou's 12 stock during the Class Period and defendants' suspiciously-timed insider sales and corporate 13 acquisitions using artificially inflated Daou stock . The second graph demonstrates that, when 14 compared to an index of similar computer and data processing companies , the inflation and eventual
15 collapse of Daou 's share prices were due to Company-specific events and not to market forces :
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2 Daou Systems, Inc, February 13, 1997 - February 12, 199 9 3
9125197 Defendants 4 exchange 150,000 shore 9 35 valued at $5 .000.000 to acquire On-Line Networking 6/25/98 Defendants exchange 1,303,631 shares valued at 527,185,080 to acquire Technology Management and Int'l HeelthCars Systems 5 8115197 Inside r Defendants sell 1,289,310 30 6126198 Defendants exchange 2,929,822 shares shares for $25,977 . 54 valued at $$1,096,280 to acquire Resources In 6 Healthcare Innov., Grand Isis Consulting, Healthcare Transition Resources, Innov . Systems Solutions and Uhl oh. 07 Defendants 25 hangs 700,000 shares 7 ad at $11;;i4F 000 to ulra Inte9
8 20 11117197 .12 OlD 7 Insider Defendant s 9 sell 28 ,408 share s 15 for $871 .03 9
10 G 1129198 Insider Defendants t sell 160, 000 share s for 3/31198 Defendants 10 ;3,662 ,800 exchange 1,558, 786 share s valued at $33,000,000 to 11 acquire Sentient and .,,nexu s 12 5
as I r C lass I P 13 0 I 02/13/97 06/12 197 10/09/97 02/06/98 06/05/98 10/01/98 02101/91 14 04115/97 08/12/97 12/08/97 04/07/98 08/04/98 11/30/9 8 15 16 Daou Systems vs. Nasdaq Computer & Data Processing 17 February 1997 - January 2000
18 500 500 19 20 400 ------400 Nasftq Computer 21 8 ------300 300 22 ai
23 200 200 24 LL 25 100 w--~---_- w -'_ - - \ ------10 0 26 0 0 FM A M J J A S O N D J F M A M J J A S O N 0 J F M A M J J A S 0 N 0 J 27 1998 1999 2000 28
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1 8. Due to defendants' deceptive and illegal conduct, lead plaintiffs and the other class
2 members purchased their Daou shares at artificially inflated prices . Had lead plaintiffs and the other
3 class members been aware of Daou's true financial results and condition, they would not have
4 purchased their shares, or at least not at the artificially inflated prices at which they purchased those
5 shares.
6 9. Finally, beginning in August 1998, defendants revealed that Daou's operating expenses
7 and margins were deteriorating and, on October 28, 1998, defendants revealed that Daou had
8 dramatically missed its projected 3Q98 earnings and would have to report a loss of $0 .17 a share.
9 Defendants further revealed that the Company's rapidly escalating work in progress account
10 represented over $10 million in unbilled receivables - the direct result of prematurely recognizing
11 revenue. These disclosures had a dramatic, negative effect on the market, causing Daou's stock to
12 decline to $3 .25 per share, a staggering 90% drop from the Class Period high of $34 .375 and a $17
13 per share drop from early August 1998 . Following these revelations, defendants conceded that Daou
14 was moving its business practice away from fixed-price contracts with revenue recognized on a
15 percentage of completion basis to charging on a time and expense basis. Nevertheless, Daou's stock
16 price has never recovered and the Company has never been able to match the artificially inflated
1 7 revenues reported during the Class Period .
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1 Daou Systems, Inc. 2 February 13,1997 - May 14, 2002 Daily Share Prices 3 40
4 Dam utilizes 8,642,238 st>wae of artificially Meted stock worth $137.681,360 to purctiase eleven businesses while the 5 IndMdual Defendants, their families and other insiders sell 30 nemty 2 .5 minion stares of Daou stock at artirctaly Inflated prfaes for a total of $54.67 mlMon in improper proceeds. 6
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14 02113/1997 1010611997 05/29/1998 0112011999 09/1 011999 05/02/2000 12/20/2000 0811412001 04112/2002 06/11/1997 02/02/1998 09/2311998 05/17/1999 01/05/2000 08/2512000 04/19/2001 12/13/2001 15
16 JURISDICTION AND VENUE 17 14. Jurisdiction is conferred by 28 U .S.C. §§ 1331 and 1337 ; §22 of the Securities Act of 18 1933 ("Securities Act"), 15 U .S.C. §77v; and §27 of the Securities Exchange Act of 1934 ("Exchange 19 Act"), 15 U.S.C. §78aa. 20 11 . The claims asserted herein arise under §§ 11,12(a)(2) and 15 ofthe Securities Act and
21 §§ 10(b) and 20(a) of the Exchange Act, 15 U .S.C. §§78j(b) and 78t(a), and Rule I Ob-5 promulgated 22 thereunder, 17 C .F.R. §240.10b-5.
23 12. Venue is proper in this District pursuant to §27 of the Exchange Act and 28 U .S.C. 24 § 1391(b). Daou had its headquarters and principal place ofbusiness in this District during the Class 25 Period. The false and misleading statements were made or issued from this District, and most of the
26 Individual Defendants live here. Thus, most of the acts and transactions giving rise to the violations 27 of law complained of occurred in this District. 28 1
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1 13 . In connection with the acts alleged in this complaint, defendants, directly or indirectly, 2 used the means and instrumentalities of interstate commerce, including, but not limited to, the mails,
3 interstate telephone communications and the facilities of the national securities markets . 11 4 THE PARTIES
5 14. Greg Sparling, Eugene Krabbenhoft, Patrick de Kruyff, Robert Zaretsky, Rod Ford, 6 Thomas V. Hagman, Richard W. Walsh, Richard Toribio and Paul Rabin (collectively "plaintiffs" or 7 "lead plaintiffs,") who were appointed as lead plaintiffs pursuant to the Court's Order, dated 8 December 14, 1998, each purchased or acquired publicly traded securities of Daou at artificially
9 inflated prices during the Class Period, and was damaged thereby . The lead plaintiffs purchased a 10 total of 66,795 shares of Daou during the Class Period and suffered damages exceeding $230,000 . 11 Appendix A hereto identifies each of the separate purchase transactions of the lead plaintiffs .
12 15. Defendant Daou is incorporated in Delaware and maintained its principal executive
13 offices during the Class Period at 5120 Shoreham Place, San Diego, California 92122 . Following the
14 Class Period, Daou closed its San Diego headquarters and what is left of the company is based in
15 Exton, Pennsylvania. At all relevant times herein, Daou was listed as a publicly held corporation
16 whose shares were traded in an efficient market on the NASDAQ National Market System
17 ("NASDAQ") .
18 16. (a) Defendant Georges J. Daou ("G. Daou") was at all relevant times Chief
19 Executive Officer and Chairman of the Board of the Company . During the Class Period, defendant
20 G. Daou sold or disposed of at least 554,937 shares of his Daou stock for proceeds of $11,241,249 .
21 (b) Defendant Daniel J . Daou ("D . Daou") was at all relevant times President and
22 a Director of the Company . During the Class Period, defendant D . Daou sold or disposed of at least
23 554,937 shares of his Daou stock for proceeds of $11,241,249 .
24 (c) Defendant Fred C. McGee ("McGee") was at all relevant times Senior Vice
25 President, Chief Financial Officer and Secretary of the Company . During the Class Period, defendant
26 McGee sold or disposed of at least 22,600 shares of his Daou stock for proceeds of $504,700 .
27 McGee exercised options to purchase 12,600 of the shares he sold for $4 .28 per share. 28
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I (d) Defendant Robert J. McNeill ("McNeill") was at all relevant times Executive
2 Vice President and Chief Operating Officer of the Company . During the Class Period, defendant
3 McNeill sold or disposed of at least 17,000 shares of his Daou stock for proceeds of $510,120 . 4 McNeill exercised options to purchase 11,060 of the shares he sold for $4 .28 per share.
5 (e) Defendant John H . Moragne ("Moragne") was at all relevant times a director
6 of the Company. During the Class Period, defendant Moragne sold or disposed of at least 328,244
7 shares of his or his related entities' Daou stock for proceeds of $7,015,075 .
8 17. The individuals named as defendants in ¶16(a)-(e) are referred to herein as the
9 "Individual Defendants." The Individual Defendants, because of their substantial ownership of and
10 positions with Daou, possessed the power and authority to control the contents of the Company's
11 quarterly reports, press releases and presentations to securities analysts, money and portfolio
12 managers and institutional investors, i.e., the market. Statements of confidential witnesses identified
13 in this Complaint reflect the Individual Defendants' actual knowledge of improper revenue
14 recognition, improper accounting practices, significant employee problems and lack of reliable
15 pipeline information throughout the Class Period . The Individual Defendants had direct conversations
16 with witnesses on these topics, discussed them in group meetings and had access to internal corporate
17 documents (including weekly and monthly project reports, pipeline reports and forecasts and reports
18 of actual operations compared thereto) . Because of their access to material nonpublic information
19 and their personal direction of Daou's revenue recognition and financial reporting, the Individual
20 Defendants each knew that the adverse facts specified herein had not been disclosed to and were
21 being concealed from the public and that the financial reports and positive representatives which were
22 being made were materially false and misleading . The Individual Defendants are liable for the false
23 statements pleaded herein at ¶124, 44, 47, 50, 53, 57, 60, 64, 67, 71 and 75, as those statements were
24 each "group-published" information, they were the result of the collective action of the Individual
25 Defendants.
26 18 . Each of the Individual Defendants except Moragne, because of their positions with 27 the Company, controlled and/or possessed the power and authority to control the contents of its
28 quarterly and annual reports, press releases and presentations to securities analysts, through whom
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1 information was conveyed to the investing public. In addition, Daou controlled each ofthe Individual
2 Defendants. These defendants are thus liable under §20(a) of the Exchange Act and § 15 of the 3 Securities Act .
4 19. None of the Individual Defendants is still an officer at Daou . 5 CONFIDENTIAL. SOURCES 6 20. The allegations of falsity and actual knowledge pled herein are made on information 7 and belief and are supported by the first-hand accounts of28 confidential witnesses, including former
8 Daou employees, consultants and customers . Confidential witnesses have been identified with as 9 much particularity as possible without disclosing their identity . Plaintiffs are informed and believe 10 that disclosing the witnesses' identities publicly, and/or to defendants, could result in serious injury
11 to the witnesses or their careers . The confidential witnesses are as follows : 12 (a) Confidential Witness #1 ("CWl") is a former Daou Project Cost Analyst . 13 CW1 was responsible for obtaining project information, such as percentage of completion estimates 14 from the project managers, and analyzing individual project budgets . CW 1's duties included entering 15 the percentage of completion information into Daou's accounting system (the ManFact accounting 16 system) after receipt from the project managers, generating project reports from ManFact, and
17 delivering those reports to Daou's Vice Presidents Ron Mirabile ("Mirabile") and Eric S . Ringwall 18 ("Ringwall"). Daou's Vice Presidents would "adjust" the reported percentage of completion estimates 19 and return the adjusted reports to CWI . CWI was responsible for entering those adjusted numbers 20 into ManFact. CW 1, along with other Daou Project Cost Analysts, was in direct communication with
21 Daou's Project Managers regarding percentage of completion discrepancies and project budget issues . 22 (b) Confidential Witness #2 ("CW2") is a former employee in Daou's Technical 23 Training Department. CW2 maintained a training file on each Daou employee enrolled in the 24 technical training program called Daou Training Standards ("DTS") .
25 (c) Confidential Witness #3 ("CW3") is a former Daou Senior Design Engineer.
26 CW3 was responsible for gathering data on Daou's projects (i.e., surveying customers' needs and then
27 developing a proposal that included network options and pricing), designing proposed networks and
28 assisting Daou's systems engineers during installation . CW3 worked closely with Daou's sales staff
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1 who would take the information gathered by CW3 and present it to the client at what was known as
2 a "technology conference." CW3 was familiar with Daou's cost estimation program which wa s 3 imbedded in an Excel spreadsheet format and linked to Daou's proposal software program. 4 (d) Confidential Witness #4 ("CW4") is a former Daou Staff Accountant . CW4 5 was responsible for keeping Daou's general ledger, which included verifying that all project
6 accounting entries were made to the proper accounts in the ManFact accounting system . Because 7 of his position as Staff Accountant, CW4 was familiar with Daou's project accounting process . 8 (e) Confidential Witness #5 ("CW5 ") is a former Daou Executive Assistant . CW5 9 worked for an executive in Daou's Field Services department and was responsible for managing 10 engineers and interfacing with customers concerning project engineering issues . 11 (f) Confidential Witness #6 ("CW6") is a former Daou executive who worked i n 12 the Finance Depa rtment. CW6 dealt with audit issues, Securities and Exchange Commission (" SEC") 13 reporting and budget matters. As such, CW6 was familiar with Daou's process of collecting project 14 cost information. CW6 reported to defendant McGee .
15 (g) Confidential Witness #7 ("CW7") is a former Financial Consultant to defendant
16 Fred McGee and was responsible for addressing various audit and SEC reporting issues . CW7 was 17 familiar with Daou's process for collecting project cost information . In addition, CW7 had knowledge 18 about Daou's cost accounting procedures, percentage of completion accounting and revenue
19 recognition determination. CW7 has first hand knowledge of conversations among the finance and 20 accounting staff concerning the validity of Daou's accounts receivable.
21 (h) Confidential Witness #8 ("CW8") is a former Daou Field Services Engineer.
22 CW8 was responsible for implementing and managing system network projects and conducting
23 analyses of potential clients' networking infrastructures . CW8 dealt directly with the customer's
24 Chief Information Officer and Senior IT or IS staff as well as Daou account managers an d 25 implementation managers, as well as Field Services Vice President Mirabile. 26 (i) Confidential Witness #9 ("CW9") is a former Daou Regional Vice President 27 of Sales. As Vice President of Sales, CW9 was responsible for reporting weekly or bi-weekly sale s
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1 information, such as sales status/backlog and forecast/pipeline information, to Daou's Vice President s 2 11 and corporate officers.
3 0) Confidential Witness #10 ("C W 10") is a farmer Daou Sales Account Manager.
4 (k) Confidential Witness #11 ("CW11") is a former Administrative Assistant t o 5 the Chief Information Officer at Candler Hospital ("Candler"), a customer of Daou . CW 11 has 6 11 personal information about the contract between Daou and Candler . 7 (1) Confidential Witness #12 ("CW12") is a former Daou Senior Network
8 Engineer. CW12 was responsible for all aspects of implementing a network system . CW12 was 9 responsible for reporting percentage of completion estimates to Daou's Vice Presidents . 10 (m) Confidential Witness # 13 ("CW 13 ") is a former Daou Accounting Department 11 Manager. As the Accounting Manager, CW13 controlled the general ledger, accounts payable, 12 payroll and accounts receivable.
13 (n) Confidential Witness #14 ("CW14") was a secu rities analyst who covered 14 Daou. CW14 conducted research regarding Daou 's earnings and participated in conference calls and 15 meetings with Daou's executives . CW14 issued reports regarding Daou 's performance to th e 16 investing public.
17 (o) Confidential Witness #15 ("CW 15 ") is a former Daou Design and 18 Implementation Engineer. CW15 was responsible for estimating the percentage of completion for
19 certain projects and for submitting the estimates to Daou's accounting department . 20 (p) Confidential Witness #16 ('"CW 16") is a former Daou Financial Analyst. 21 CW16 is familiar with the procedure by which Daou received employee time entries for each project
22 from the field. CW16 has knowledge about the monthly reports generated from ManFact and the 23 monthly pipeline reports. CW16 is also knowledgeable about who at Daou received these monthl y
24 reports.
25 (q) Confidential Witness #17 ("CW17") is a former Daou Financial Analyst . 26 CW l 7 was responsible for job costing. CW 17 is familiar with the procedure by which Daou received 27 employee time entries for each project from the field . CW 17 has knowledge about the monthl y
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I reports generated from ManFact (such as the Monthly Project Report) and the Monthly Pipeline
2 Report. CWl7 has personal knowledge about who at Daou received these monthly reports . 3 (r) Confidential Witness #18 ("CW18") is a former Daou Financial Consultant. 4 CW18 has knowledge about Daou's weekly forecast reports which compared actual results t o 5 I budgeted results. 6 (s) Confidential Witness #19 ("CW19") is a former officer at Mercy Health 7 Services Corp. CW19 is knowledgeable about the quality and availability of service provided by
8 Daou's on-site technicians. CW19 is also knowledgeable about the fact that Daou was not retaining
9 employees such as technicians and account managers . In addition, CW 19 has communicated directly
10 with defendant G . Daou concerning bids on certain projects and problems that arose thereafter .
11 (t) Confidential Witness #20 ("CW20") is a former Daou Field Services Engineer .
12 CW20 worked on-site at several Daou customer locations .
13 (u) Confidential Witness #21 ("CW21 ") is a former Daou Field Services
14 Technician. CW21 is familiar with the quality of technical work performed by Daou technicians .
15 CW21 is knowledgeable about Daou's "burn-in" practice .
16 (v) Confidential Witness #22 ("CW22") is aformerDaou Sales Account executive .
17 CW22 was responsible for developing and contracting new business .
18 (w) Confidential Witness #23 ("CW23") is a former Executive Assistant . CW23
19 attended Daou 's Board of Director meetings and had frequent contact with various Daou executives.
20 (x) Confidential Witness #24 ("CW24 ") is a formerDaou Project Manager . CW24
21 has firsthand knowledge regarding Daou 's contracts with the University of Chicago .
22 (y) Confidential Witness #25 ("CW25") is a former Daou division Director .
23 CW25 was responsible for contract outsource management personnel .
24 (z) Confidential Witness #26 (" CW26") is a former Daou Field Services Engineer .
25 CW26 worked on-site at several Daou customer locations .
26 (aa) Confidential Witness #27 ("CW27") is a former Manager in Daou's Accounting
27 Department.
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1 (bb) Confidential Witness #28 ("CW28") is a former Daou Sr. Network Engineer 2 and Project Manager. CW28 had regular personal communication with Daou's Vice Presidents and
3 was responsible for reporting percentage of completion estimates to them .
4 DAOU'S FALSE FINANCIAL REPORTING DURING THE CLASS PERIOD 5 Percentage of Completion Accounting
6 21 . In accounting for income from long-term construction type contracts , one method 7 permitted under GAAP is the percentage of completion ("POC") method . POC accounting is 8 intended to recognize income as work progresses based on either the percentage of costs incurred
9 divided by total estimated costs or the percentage of labor incurred divided by total estimated labor 10 hours. See Accounting Research Bulletin ("ARB") No. 45, 14. An essential component of POC 11 accounting is the ability to maintain a defensible and reasonable degree of accuracy in identifying both 12 total labor costs and labor costs incurred. Recognition of revenue under POC accounting is not 13 simply a matter of business judgment , but must be based on a comprehensive review of each
14 individual contract, the actual costs or labor incurred and a "realistic estimate of costs [for labor] to 15 complete all phases of the contract ." See AICPA Manual at §8.10. Moreover, the mere purchase 16 of generic raw materials, such as computer equipment, does not qualify as a labor cost incurred. See 17 AICPA Statement of Position ("SOP") No. 81-1 .50. According to GAAP, as set forth in AICPA 18 SOP No. 81-1, percentage of completion income recognition is a specific methodology intended to
19 present the accurate economic substance of a company's transactions . See SOP 81-1 .22.
20 22 . GAAP are those principles recognized by the accounting profession as the
21 conventions, rules and procedures necessary to define accepted accounting practices at a particular
22 time. SEC Regulation S-X (17 C .F.R. §210.4-01(a)(1)) states that financial statements filed with the
23 SEC which are not prepared in compliance with GAAP are presumed to be misleading and inaccurate,
24 despite footnote or other disclosure. Reg S-X requires that interim financial statements must also
25 comply with GAAP, with the exception that interim financial statements need not include disclosures
26 that would be duplicative of disclosures accompanying annual financial statements . 17 C.F.R.
27 §210.10-01(a). 28
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1 23 . The Securities and Exchange Commission ("SEC") has noted that "Percentage of
2 Completion accounting requires that there be an accurate method to measure what portion of a job 3 has been completed." SEC Accounting and Auditing Enforcement Release ("AAER") No, 356
4 (March 2, 1992) . The SEC has also brought enforcement actions for failure to properly recognize 5 revenue under the percentage of completion method where a company's senior management 6 recognized revenue in excess of the percentage of work performed as reported by the company's 7 project manager . See AAER No. 274 (Sept. 26, 1990).
8 Defendants' Manipulation of Percentage of Completion Accountin g 9 24. Defendants represented to shareholders and the market that Daou complied with
10 GAAP and the Company's own POC accounting policy. Dacu's 1997 Form 10-K represented that : 111 REVENUE RECOGNITION
12 Contract revenue for the development and implementation of network solutions is recognized on the percentage-of-completion method with progress to 13 completion measured by labor costs incurred to date compared to total estimated labor costs . Provisions for estimated losses on contracts, if any, are made during the 14 period when the loss becomes probable and can be reasonably estimated . Revenues recognized in excess of amounts billed and project costs are classified as contract 1 5 work in progress. Revenue from technical support and network management services is recognized over the period the services are performed. Payments received in 16 advance of services performed are recorded as deferred revenue and amortized as the services are performed. 17 25. In truth, during the Class Period, defendants did not comply with GAAP or Daou's 18 stated manner of recognizing revenue under POC accounting . Daou reported the following quarterly 1 9 amounts during the Class Period (prior to the restatement of Daou's results pursuant to its 20 acquisitions): 21
22 3/31/97 6/30/97 9/30/97 12/31/97 3/31/98 6/30/9 8 Revenue $5 .2 M $6.OM $11.3M $14.5M $18.1M $28.0 23 Net Income ($ .2 M) $ .05 M $ .6 M* $ .7 M $ 1.4 M* $2.2M* 24 EPS ($0.02) $0.01 $ 0.05* $0.06 $0.10* 50.12* 25 * Excluding merger charges . 26
27 28 II
- 15- 98cv1537-L(CGA) 1 26. The above results were reported in press releases issued by Daou. Daou also included 2 its interim results in reports on Form 10-Q filed with the SEC .' With regard to the financial 3 information included in the Form 10-Q's, Daou represented that "in the opinion of management," its 11 4 financial statements "fairly present[ed]" the Company's results and financial position . The 5 December 31, 1997 results were incorporated in Daou's annual 1997 financial statements filed with 6 the SEC in a report on Form 10-K . Daou also included its fourth quarter and year end December 31, 7 1996 results in its February 13, 1997 Initial Public Offering ("IPO") Prospectus and Registration 8 Statement as follows :
9 Qtr Year 12/31/96 12/31/96 10 Revenue $7.OM $19.3M 11 Net Income $ .066M ($ .402M) EPS (Pro Forma) $ .0 1 12 27 . As detailed herein, defendants caused Daou to falsify its reported financial results 13 through the recognition of revenue in advance of earning such revenue or being entitled to record the 14 revenue. Specifically, defendants did not record revenue based on the percentage of actual labor 15 costs incurred compared to labor costs estimated . First, defendants recognized up to 50% or more 16 of the total value of new contracts when little or no actual labor costs had been incurred and without 17 regard to the actual percentage of completion . Second, defendants inflated the percentage of actual 18 labor costs incurred to total estimated labor costs that were submitted by Daou's project managers . 19 Third, defendants grossly underestimated projections of total labor costs needed to complete 20 contracts that had no reasonable basis and were disputed by Daou's on-site managers . Each of these 21 schemes violated both GAAP and Daou's stated accounting policy and served to prematurely inflate 22 Daou's reported revenue by millions of dollars . 23 28. Confidential witnesses from Daou's Field Services and Accounting departments 24 individually and collectively described defendants' recognition of revenue before labor costs were 25 incurred. Immediately upon signing installation and implementation contracts, defendants would 26
27 1 When Daou subsequently issued its Form 10-Q for the quarter ended 6/30/98, it had 28 reclassified merger charges from the figures it reported in the July 29, 1998 call with analysts, and earnings before charges were reduced to approximately $800,000 .
-16- 98cv1537-L(CGA) 0
1 record 20% of the total contract value as revenue, prior to work being performed or any labor costs
2 being incurred. Upon ordering the equipment for a project, which occurred on at least one occasion 3 before the project contract was signed, defendants would record 40% of the total contract value as 4 revenue. Confidential witnesses further confirm that 50%-60% of the total contract value would be 5 recognized as revenue as soon as the contract equipment was configured and tested in Daou's
6 facilities. Accordingly, Company sources confirm that 50% or more of the revenue from Daou's
7 contracts was recognized when little or no labor costs had been incurred . The installation and
8 implementation projects were labor-intensive and the majority of labor costs were incurredafter any 9 equipment was shipped to the project location . Recognizing revenue based on a contract signing or 10 equipment orders, with no relation to the labor costs incurred or percent of the project completed, 11 violated both GAAP and Daou's accounting policy, revenue, as described above, was only to be
12 recognized as work actually progressed on the contract . See ARB No . 43, ¶4.
13 29. For projects with ongoing labor costs, defendants inflated the percentage of labor 1 4 costs incurred. Field Services Project M anagers tracked billable hours and projected hours on Daou's 15 job costing sheet. On a monthly basis, these figures were compiled into a single Monthly Project
16 Report covering all of Daou's then existing contracts . According to confidential witnesses, following 17 the defendants' month and quarter end review of the Project Repo rt, Field Services executives would 18 tell the project managers to alter their projected hour calculations or would manually change the
19 project manager's repo rts in the Company's ManFact accounting system. In doing so, defendants 20 were able to reco gnize revenue on contracts prematurely , thereby violating GAAP requirements that 21 the revenue recognized have a reasonable basis because defendants did not use the labor cost incurred 22 and estimated labor cost figures provided by the actual project managers. 23 30. Defendants also manipulated Daou's reported revenue by failing to use accurate o r 24 reasonable estimates of the estimated labor costs necessary to complete contractual terms . Again, 25 according to confidential witnesses, defendants failed to apply accurate estimates of total labor costs 26 necessary as supplied by the Company's project managers and engineers . Defendants utilized 27 materially lower project estimates in order to more quickly recognize revenue . As a result, the
28
-17- 98cvl537-L(CGA) C7 E
1 percentage of revenue recognized exceeded the percentage ofthe project actually completed or labor
2 costs necessary, a violation of GAAP and Daou's stated accounting policy.
3 31 . Specific instances of each of the above practices are identified herein at ¶¶44, 47, 50,
4 53, 57, 60, 64, 67, 71 and 75 .
5 Impact of Defendants' Accounting Frau d 6 32. Defendants violated GAAP and Daou's stated accounting policy in order to inflate its 7 revenues and earnings by immediately recognizing revenue on contracts before labor costs were
8 incurred and arbitrarily altering its percentage completion estimated to result in higher revenues. As 9 a result, Daou reported revenue well before it was entitled to pursuant to GAAP . This resulted in 10 Daou accumulating large amounts of accounts receivable it could not collect, including millions in
11 receivables it was not entitled to bill to its customers . Note the following :
12 -The contract work in progress account on Daou's balance sheet, which included amounts
13 Daou had recognized as revenue but for which it was not entitled to bill its customers and
14 amounts of implementation costs it had incurred but had not yet recognized as an expense
15 against earnings, grew from less than $400,000 in 1995 to more than $22 million in Q2 1998 .
16 Even though reported net income was increasing, Daou was experiencing a marked
17 increase in its quarterly cash flow deficit from operations (in thousands )
18 0 1 97 02 97 03 97 4 97 0 i 98 $455 $1,605 $3,123 $6,957 19 $7,18 4
20 Accounts receivable grew from only $3 .4 million at 3/31/97 to nearly $20 million at 21 6/30/98.
22 • Gross margins were also inflated by Daou's improper revenue recognition, increasing
23 to 40% in Q 11998 . Following the end of the Class Period, gross margin dropped
24 precipitously, to a mere 15% in Q4 1998 . This results from Daou now completing work
25 which it had previously reported as revenue .
26 Days sales outstanding (a measure of the estimated time to collect receivables) for
27 receivables and contract work in progress was 182 days at 3/31/98 and was 136 days by
28 6/30/98 .
_18- 98cv1537-L(CGA) C7 E
1 • The contract work in progress account continually became a much more significant 2 part of Daou's financial statements as Daou continued to recognize additional revenue and
3 post more unbilled receivables to this account . Following the end of the Class Period, 4 contract work in progress in both dollar amount and as a percentage of total assets returned 5 to lower levels. Note the following charts :
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
- 17 - 98cv1537-L(CGA) •
1 33. In fact, had Daou reported its revenues in line with the amounts it was entitled to bill
2 customers pursuant to its contracts, it would have repo rted materially lower revenue in each quarter 3 during the Class Period :
4 1097 2297 3097 4Q97 1098 2098 Reported 5 Revenues $5.2 M $6.0 M $11 .3 M $14.5 M $18 .1 M $28.0 M
6 Revenues as per billing $4.1 M $5 .6 M $5,9 M $ 12.8 M $10.3 M $25.8 M 7 Daou's 1996 revenues, reported to be $19.3 million, also would have been materially lower -j at only 8 $16.0 million. The difference between Daou's publicly repo rted revenue and the revenue that should 9 have been recognized and reported under GAAP is material: 10 Reported Revenues Revenues as per Billing % of Revenue 11 1097 - 2098 1097 - 2098 Material Difference Overstatement
12 $83.1M $64.5M' $18.6M 28 .8% 13 34. Due to these accounting improprieties, the Company presented its financial results and 14 statements in a manner which violated GAAP, including the following fundamental accounting 15 principles: 16 (a) The principle that financial repo rting should provide information that is useful 17 to present and potential investors and creditors and other users in making rational investment, credit 18 and similar decisions was violated (FASB Statement of Concepts No . 1,134); 19 (b) The principle that financial reporting should provide information about the 20 economic resources of an enterprise, the claims to those resources, and effects of transactions , events 21 and circumstances that change resources and claims to those resources was violated (FASB 22 Statement of Concepts No. 1, ¶40); 23 (c) The principle that interim financial repo rting should be based upon the same 24 accounting principles and practices used to prepare annual financi al statements (APB No . 28, ¶12); 25 (d) The principle that financial reporting should provide information about how 26 management of an enterprise has discharged its stewardship responsibility to owners (stockholders) 27 for the use of enterprise resources entrusted to it was violated . To the extent that management offers 28
-20- 98cv1537-L(CGA) 0 0
1 securities ofthe enterprise to the public, it voluntarily accepts wider responsibilities for accountability
2 to prospective investors and to the public in general (FASB Statement of Concepts No. 1,150); 3 (e) The principle that financial reporting should provide information about an 4 enterprise's financial performance during a period was violated. Investors and creditors often use 5 information about the past to help in assessing the prospects of an enterprise. Thus, although 6 investment and credit decisions reflect investors ' expectations about future enterp rise performance,
7 those expectations are commonly based at least partly on evaluations of past enterp rise performance 8 (FASB Statement of Concepts No. 1, ¶42); 9 (I} The principle that financial reporting should be reliable in that it represents
10 what it purports to represent was violated . That information should be reliable as well as relevant is .11 a notion that is central to accounting (FASB Statement of Concepts No . 2, ¶'58-59); 12 (g) The principle of completeness, which means that nothing is left out of the 13 information that may be necessa ry to insure that it validly represents underlying events and conditions 14 was violated (FASB Statement of Concepts No . 2, ¶79); and 15 (h) The principle that conservatism be used as a prudent reaction to unce rtainty 16 to try to ensure that uncertainties and risks inherent in business situations are adequately considered
17 was violated. The best way to avoid injury to investors is to try to ensure that what is repo rted 18 represents what it purpo rts to represent (FASB Statement of Concepts No. 2,1¶95, 97).
19 35. Further, the undisclosed adverse information concealed by defendants du ring the Class 20 Period is the type of information which, because of SEC regulations, regulations of the national stock 21 exchanges and customary business practice , is expected by investors and secu rities analysts to be 22 disclosed and is known by corporate officials and their legal and financial advisors to be the type of 23 information which is expected to be and must be disclosed .
24 DEFENDANTS ' INSIDER TRADING AND USE OF ARTIFICIALLY INFLATED STOCK FOR ACQUISITIONS 25 36. Defendants' insider trading and use of Daou's artificia lly inflated stock to make 26 corporate acquisitions support a strong inference of scienter. While defendants were issuing the false 27 statements identified herein about Daou 's financial results and business, the Individual Defendants sold 28 at least 1,477,718 shares of Daou stock - only days after issuing favorable statements about th e
- 21 - 98cv1537-L(CGA) 1 Company - for proceeds exceeding $30 .5 million, thereby personally profiting from the artificial 2 inflation in Daou's stock price which their fraudulent scheme had created . Notwithstanding their 3 knowledge about Daou's improperly recognized revenue and their duty as officers and directors of 4 Daou to disclose adverse material facts before trading in Daou stock, the Individual Defendants sol d
5 enormous amounts of Daou shares at artificially inflated prices in order to profit from the fraud . 6 Defendants' insider selling during the Class Period is detailed below :
7 SHARES SOLD! PRICE PE R DEFENDANT DATE SOLD DISPOSED OF SHARE VALUE 8 Georges J . Daou 08/15/97 479,937 $19 .85 $ 9,526,74 9 01/29/98 75.000 $22.86 $ 1 .714,500 9 554.937 $11,241,249
10 Daniel J. Daou 08/15/97 479,937 $19 .85 $ 9,562,749 01/29/98 75,000 $22.86 $ 1,714,500 11 554.937 $11,241,249
12 Fred C. McGee 08/15/97 12,600 $21 .50 $ 270,900 01/29/98 10,000 $23 .38 233,800 13 22 $ 504,700
14 Robert J. McNeill 12/22/97 2,000 $30 .06 $ 60,120 12/29/97 9,000 $30 .00 $ 270,000 15 12/30/97 6,000 $30.00 $ 180,000 17,000 $ 510,120 16 John H. Moragne 08/15/97 308,233 $21 .00 $ 6,472,89 3 17 08/15/97 8,603 $21 .00 $ 180,663 11/17/97 11,408 $31 .69 $ 361,51 9 18 328,244 $ 7,015.075
19 TOTALS : 1,477,718 $30,512,393
20 37. The percentage of each defendants' massive insider selling during the Class Period i s 21 summarized below :
22 Shares Total % of Class Period Sales as a Beneficially Owned Holdings Holdings % of Total Sales from 23 Defendant 2/12/97 (1) with Options (1) Sales Sold 2/13/97-12/31/00 G. Daou 1,957,361 1,957,361 554,937 28 .35% 100% 24 D. Daou 1,952,361 1,952,361 554,937 28,42% 100% F. McGee 0 28,060 22,600 80 .54% 50% (2) 25 R. McNeill 0 25,254 17,000 67 .32% 100% J. Moragne 737,083 751,099 328,244 43 .70% 100 % 26 (1) Form 3 Initial Statement of Ownership filed with the SEC . 27 (2) F . McGee sold 22,600 shares on 9/14/99 . 28
-22- 98cv1537-L(CGA) 1 38. These sales were not merely unusual in amount, but also were made at suspicious
2 times. No defendant was engaged in a fixed pattern of sales . No defendant other than McGee has
3 ever sold Daou shares except those sold during the Class Period . Further, the fact that 98% of all
4 insider sales, totaling $29 .6 million, took place on only two trading days (August 15, 1997 and
5 January 29, 1998) is highly suspect and indicative of coordinated selling among defendants. The
6 Individual Defendants also timed their sales to take advantage of the huge increase in the price of
7 Daou stock that immediately followed their false statements and reports and recommendations of
8 securities analysts who based their favorable investment ratings on information provided by
9 defendants concerning Daou's financial results . The January 29, 1998 insider sales occurred only one
10 week after defendants reported Daou's "record" 4Q and FY97 results . The August 15, 1997 sales,
I 1 made within one month of Daou's all-time high stock price, were coordinated concurrently with false
12 representations in its Prospectus and Registration Statements about the Company's adherence to its
13 accounting policy and "record" IQ and 2Q97 results . The named defendants were not the only
14 insiders to profit from the fraud . Daou insiders, including Senior Vice President Dan L . Porter - who
15 sold 100% of his holdings between November 19, 1997 and December 30, 1997 - Jonathan Kendall
16 and J. Kirby Farrell, dumped at least 351,029 of their shares, all at the same time defendants were
17 unloading their Daou stock, at artificially inflated prices for proceeds of $6,098,976 . And, the
18 families of defendants G. Daou and D. Daou, including Joseph Daou (father and former Treasurer
19 of Daou), Katherine Daou, Anne Daou and Elizabeth Daou, dumped at least 651,216 shares of the
20 Company's stock during the Class Period based on adverse, non-public information for proceeds of
21 $18,061,277 . All told, defendants, their families and Daou insiders sold nearly 2.5 million shares of
22 Daou stock at artificially inflated prices for a total of $54.67 million in improper proceeds .
23 39. Each of the Individual Defendants also had motive to inflate Daou's stock price and
24 perpetrate the fraudulent scheme and course of business complained of to complete corporate
25 acquisitions. During the Class Period, Daou was actively engaged in reviewing several potential
26 acquisitions to grow its business and customer base . However, as of June 30, 1997, Daou had only
27 $14.5 million in cash and was experiencing net losses for the second straight quarter since the
28 Company's IPO . Because Daou needed to conserve its cash to fund ongoing operations, it had to us e
-23- 98cv1537-L(CGA) 0 v
1 stock for acquisitions. Using Daou stock to pay for acquisitions, however, meant that it was of 2 critical importance for Daou to repo rt profitable growth and a strong financial condition to keep its 3 stock price at high levels so that Daou stock would appear attractive to the businesses Daou was
4 attempting to acquire. This put tremendous pressure on Daou's executives to present its business and 5 finances in a very favorable light. Defendants succumbed to this pressure when they improperly 6 recognized revenue through their abuse of the POC method and recognized revenue in advance of
7 earning it, or being entitled to record it, in violation of GAAP. Defendants were successful as Daou 8 acquired 11 companies during the Class Period by exchanging over 6 .6 million shares ofDaou stock II, 9 valued at almost $140 million . The following is a list of the companies acquired and the number of 10 shares Daou "saved" by inflating the price of the Company's stock:
11 DAOU ACQUISITIONS 12 Daou Shares Value of No. Of Shares "Saved" Exchanged in Exchanged Daou by Artificially 13 Inflatin g Acquired Company Date Acquisition Shares Daou's Stock Price (1 )
14 INTEC}REX Systems Corp . July 1997 700,000 $ 11,400,000 1,476,40 3
15 On-Line Networking, Inc. Sept . 1997 150,000 $ 5,000,000 804,56 3
16 Sentient Systems, Inc. March 1998 1,397,55 0 $ 30,000,000 4,329,827 Synexus, Inc . March 1998 161,235 $ 3,000,000 411,503 17 Technology Management, Inc. June 1998 1,078,963 $ 22,500,000 3,216,57 0 18 International HealthCare June 1998 224,66 8 $ 4,685 ,080 669,773 19 Systems, Inc .
20 Resources in Healthcare June 1998 1,839,38 1 $ 38,357,000 5,483,45 2 Innovations
21 Grand Isle Consulting, Inc. June 1998 223,645 $ 4,663,730 666,720
22 Healthcare Transition June 1998 275,662 $ 5,748,460 821,79 1 Resources, Inc . 23 Innovative Systems Solutions, June 1998 308,58 3 $ 6,434,970 919,93 4 24 Inc.
25 Ultitech Resources Group, Inc. June 1998 282,55 1 $ 5,892 .120 842,329 TOTALS: 6,642,23 8 S 137,681,360 19,642,865 26 *Based on 90 day average stock price from 10/28/98 - 1/26/99 of $5 .24. 27
28
-24- 98cv1537-L(CGA) v n
1 40. According to Daou's 2Q97 10-Q, Daou had 50,000,000 shares of common stock
2 authorized, and of that number, 10,267,678 was issued and outstanding as of June 30, 1997 . 3 Therefore, if defendants had not artificially inflated the price of Daou's stock, they would have had
4 to issue an additional 19 .6 million shares (a total of 26.3 million shares) to complete the acquisitions. 5 With only 40,000,000 shares available to issue and a low cash balance, the ability to issue more shares
6 necessary to support Daou's aggressive acquisition spree would have been difficult, if not impossible . 7 Recognizing this, defendants added the following language into the August 15, 1997 Prospectus : 8 "Future sales of substantial amounts of Common Stock in the public market could adversely affect
9 market prices prevailing from time to time and the ability of the Company to raise equity capital in 10 the future. " 11 41 . The Individual Defendants' desire to sell their own and/or Daou's stock on the
12 February 13, 1997 IPO and the August 15, 1997 Secondary Offering also provided them with a 13 motive to inflate Daou's stock price . If Daou's share price remained at an inflated level as a result of 14 defendants' false statements and improper accounting, the defendants could take advantage of the 15 inflated price for their own financial enrichment, before the undisclosed adverse information known
16 to defendants became public and Daou's stock price collapsed, The IPO of two million shares at 17 $9.00 per share raised Daou a net of $15 .8 million. The August 19, 1997 Secondary Offering of 18 2,365,000 shares of the Company's common stock further enabled Daou to raise a net $9 .3 million 19 in badly needed cash and the Individual Defendants and insiders to unload nearly $26 million worth 20 of their individual stock holdings at artificially inflated prices before the truth about Daou's fraudulent
21 accounting practices became public :
22 Shares Sold in Proceeds From Defendants 8/15/97 Offering 8/15/97 Offering 23 Daou Systems, Inc . 500,000 $9,300,000 Daniel Daou 479,937 9,526,749 24 Georges Daou 479,937 9,526,749 John Moragne (including affiliates) 316,836 6,653,55 6 25 Fred McGee 12,600 270,900 TOTALS: 1,789,310 $35,277,954 26 Even after the August 15, 1997 Secondary Offering was completed, the Individual Defendants and 27 28 other insiders and related parties continued to sell off more of their own Daou stock to pocket millions more in illegal insider trading proceeds for themselves .
-25- 98cv1537-L(CGA) 0 0
1 42. As is further alleged herein, defendants improperly recognized revenue through the
2 gross abuse of the POC method of accounting and recognized revenue before it was earned or before
3 Daou was entitled to record the revenue in violation of GAAP . This artificially inflated the price of
4 Daou stock so that Daou could sell a net $25 .1 million in stock on its offerings, the Individual
5 Defendants could dispose of more than $30 .5 million worth of their own Daou common stock in the
6 August 15, 1997 Secondary Offering and in the open market, other Daou affiliates and insiders could
7 sell at least $24 million of their Daou stockholdings at inflated prices and defendants could make
8 $137.7 million in corporate acquisitions .
9 DEFENDANTS' FRAUDULENT SCHEME AND COURSE OF BUSINES S 10 43 . Each of the defendants is liable as a participant in a fraudulent scheme and course of 11 business that operated as a fraud or deceit on purchasers ofDaou stock, including the making of false 12 and misleading statements and/or concealing material adverse facts. The fraudulent scheme and
13 course of business: (i) deceived the investing public regarding Daou's finances and business ; 14 (ii) deceived the investing public regarding Daou's success in generating revenues and earnings ; 15 (iii) artificially inflated the price of Daou stock; (iv) caused lead plaintiffs and other members of the 16 Class to purchase Daou stock at inflated prices ; (v) permitted Daou and the Individual Defendants 17 to sell 2,000,000 shares of stock on the February 13, 1997 IPO, 2,365,000 shares of stock in a 18 August 15, 1997 Secondary Offering, and more shares of their holdings in the open market, all at
19 artificially inflated prices; and (vi) permitted defendants to use only 6 .6 million shares of stock to 20 acquire 11 separate companies with a value of $137 .7 million.
21 FALSE AND MISLEADING STATEMENTS DURING THE CLASS PERIO D 22 44. Defendants' false and misleading statements in Daou's initial public offering 23 prospectus:
24 (a) On February 13, 1997, defendants offered and sold in an IPO 2,000,000 shares
25 of Daou's common stock to the public at $9 per share . In the Registration Statement and Prospectus
26 issued in connection with the IPO and signed by defendants G . Daou, D . Daou, McGee and Moragne,
27 defendants represented that Daou typically provided its services on a fixed fee basis and that the
28 Company recognized revenue using the POC accounting method :
I -26- 98cv1537-L(CGA) 0 0
1 Contract revenue for the development and implementation of network solutions is recognized on the percentage-of-completion method with progress to 2 completion measured by labor costs incurred to date compared to total estimated labor costs . Provisions for estimated losses on contracts, if any, are made during the 3 period when the loss becomes probable and can be reasonably estimated . Revenues recognized in excess of amounts billed and project costs are classified as contract 4 work in progress .
5 (b) Defendants further represented in the Prospectus that "[c]ertain contract
6 payment terms may result in customer billing occurring at a pace slower than revenue recognition . 7 The resulting revenue recognized in excess of amounts billed and project costs are classified as
8 contract work in progress on the Company's balance sheet ." For 4Q96, Daou reported in the 9 Prospectus revenues of $6,954,000, operating earnings of $126,000, accounts receivable of 10 $4,085,000, and contract work in progress of $3,600,000 . For FY96, Daou reported in the I 1 Prospectus revenues of $19.3 million. 12 45. Reasons why defendants' statements in Daou's Prospectus were false and
13 misleading: Defendants' statement that Daou recognized revenue on the basis of labor costs incurred
14 to date compared to total estimated labor costs and Daou's reported 4Q96 revenues of $6 .95 million 15 were false when made . The following facts, corroborated by the accounts of at least seven 16 confidential witnesses, including accounting, engineering, and executive personnel who were based 17 inDaou's San Diego headquarters and at specific Company projects, confirm that, in truth, defendants 18 failed to accurately employ POC accounting and that Daou's reported financial results were the result 19 of defendants' improper revenue recognition in violation of GAAP and the Company's stated 20 accounting policy:
21 (a) Defendants did not recognize revenue in accordance with POC accounting
22 requirements or Daou's stated accounting policy . POC accounting and GAAP require that revenue
23 not be recognized before it is earned and that all revenue recognized be based on the accurate
24 measure of the labor costs to date compared to the total estimated labor costs for the project .
25 According to CW5, a former engineer and assistant to one ofDaou's Field Services executives, during
26 4Q96 and throughout FY97, POC revenue was recognized on Daou's contracts without regard to
27 actual labor costs incurred or projected . CW5, who dealt with accounting for ongoing contracts
28 under defendant McNeill, confirmed that defendants would automatically record 20% of the revenu e
-27- 98cv1537-L(CGA) v C
I from a contract upon contract signing, p rior to any labor costs being incurred . Forty percent of the 2 revenue from contracts was recognized immediately after any equipment was ordered and 50%-60%
3 of the revenue was recognized as soon as the equipment was "burned-in" (configured and tested) . 4 CW5 confirmed that this revenue was recognized without regard to labor costs incurred .
5 (b) CW28, a former senior network engineer and project manager , who worked 6 on Daou's Mercy Health Services project, confirmed that a fixed amount of revenue was recognized
7 on contracts immediately upon signing , and that the revenue repo rted by defendants did not reflect 8 labor costs incurred compared to total estimated labor costs . CW9, a former Daou Vice President
9 in the Sales Department, further confirmed the accuracy of CW5's and CW28's reports and identified 10 that during this period defendants would recognize a fixed percentage of revenue immediately upon
1 I a contract signing and upon ordering equipment, even when no labor costs were incurred. 12 (c) 4Q96 revenue was artificially inflated to present the image of strong growth
13 and to promote Daou's IPO. CW8, a Field Services Engineer during 4Q96, and CW3, a Senior 14 Design Engineer during 4Q96, both confirmed that it was known throughout Daou at this time that 15 G. Daou, D . Daou and McNeill were engaged in improper revenue recognition and that revenue on
16 POC contracts was being recognized prematurely (before labor costs were incurred) . According to 17 CW5, CW9, CW28 and CW3, this premature and improper revenue recognition - violating GAAP 18 and Daou's stated accounting policy - was not limited to one or two contracts, but was true for all 19 or virtually all Daou projects, including the 4Q96 Mercy Health Services project .
20 (d) Defendants' statements about Daou's accounting policy and 4Q96 revenue
21 were also false because, in addition to the immediate recognition of revenue after a contract was
22 signed or equipment was ordered (and at a time when little or no labor costs had been incurred),
23 defendants manipulated the actual labor costs incurred and estimated total labor costs . According
24 to CW28 and CW 12, both Field Services Engineers in 4Q96 and into FY97, the estimates of total 25 labor costs provided by senior managers at project sites were routinely ignored for revenue
26 recognition purposes . The estimates of total labor hours used to calculate revenue by defendants G .
27 Daou, D. Daou, McNeill and McGee were, according to CWI 2, grossly understated and did not
28 reflect the opinions of the on-site managers . CW28 further confirms that, during this period, he was
-28- 98cv1537-L(CGA) 1 told by Field Services Vice President Mirabile, who worked at the direction of defendant McNeill,
2 what percent complete his projects were (for revenue recognition purposes) and that these figures
3 did not reflect the actual labor completed or labor required to complete the projects . According to 4 CW28, based on his firsthand knowledge from Daou projects, the actual percentage of completion
5 numbers were adjusted upward by Daou's senior executives to boost reported revenue . 6 (e) CW2, a training manager based in Daou's headquarters during 4Q96, reported 7 that he was specifically told by both a senior-level network engineer and a Field Services project
8 manager that defendants' revenue recognition on their projects was improper and was not based on 9 Daou's stated POC accounting policy . As a result, according to CW2, both the network engineer and
10 project manager left Daou after making their complaints about improper revenue recognition . 11 46. Defendants' knowledge of falsity : Based on the reports of numerous witnesses, all 12 of whom were former members of Daou's Executive, Accounting or Field Services staff, defendants 13 not only knew that Daou failed to follow its stated POC accounting policy, but personally directed
14 the violations of Daou's policy and GAAP in order to artificially inflate revenues . 15 (a) Defendants G. Daou, D. Daou, McNeill and McGee personally directed Daou's 16 recognition of revenue, financial reporting and public statements . Not only were these four 17 defendants the top executives at Daou, but, according to CW23, a former executive assistant to one 18 of the defendants, the Company was run "top to bottom" by G . Daou and D. Daou, with the 19 assistance of McNeill and McGee . G. Daou and D . Daou, confirmed CW23, were particularly 20 concerned with the Company's revenue recognition in advance of the IPO and on a quarterly basis,
21 and made the final decisions on POC accounting revenue to be recognized .
22 (b) CW13 confirmed that McNeill provided G . Daou and D. Daou with all raw
23 POC and revenue recognition figures and that, together with McGee, they personally determined
24 what revenue Daou would publicly report . According to CW5, who reported to McNeill, McNeill,
25 G. Daou and D. Daou paid particularly close attention to the POC and revenue recognition numbers,
26 and were, with McGee, the only people at Daou who could determine how much revenue to publicly
27 report . CW15 further confirmed that all decisions regarding recognition of revenue on Daou's
28 contracts were made by McNeill, G. Daou and D. Daou.
-29- 98cvl537-L(CGA) • E
I (c) CW9, a regional Sales Vice President at Daou , confirmed that defendants 2 G. Daou, D. Daou and McNeill not only made the decision on how much revenue to recognize
3 without regard to any actual percentage of completion , but directed the practice of automatically 4 recognizing revenue upon contract signing and ordering of equipment. Accordingly, from their own 5 actions, these defendants knew their statements about Daou's accounting policy and revenue 6 recognition were false and misleading when made .
7 (d) All of the defendants knew how Daou's results were progressing in 4Q96 and
8 knew that the reported revenue could only be achieved by manipulating the Company's financial
9 results. CW1, CW5, CW7, CW12, CW17 AND CW21 all confirm that both actual labor costs
10 incurred/completed and the estimates used to falsify Daou's revenue recognition were recorded under
11 the direction of McNeill and distributed to G . Daou, D. Daou, McGee and , periodically, to directors,
12 including Moragne . Each employee on a Daou project was provided with a workbook containing the
13 template for an Excel spreadsheet. The spreadsheet (the job costing sheet) contained categories for
14 hours worked , along with travel and non-billable time. For each time period (initially Sunday to
15 Sunday, later changed to bi-weekly), the Job Costing Sheet was provided to the project manager .
16 The project manager would compile the billable time, make an estimate , based on the time and costs
17 incurred to date, of the percent of the project that was complete and e-mail the information to Daou's
18 project cost accounting staff in San Diego, who operated under McNeill. CWI, a project cost
19 analyst, stated that the time and percentage of completion data was entered into the Company's
20 ManFact accounting system . One or two days before the end of the month, Technical Services Vice
21 President Ringwall and Field Services Vice President Mirabile would print out the ManFact reports
22 containing actual labor and percent completion submitted by project managers, for the current month
23 and quarter. According to CW1, CW3, CW4, CW7, CW16, the ManFact data was compiled into a
24 Monthly Project Report which was sent to G. Daou, D. Daou, McGee, and McNeill at the close of
25 each month and quarter. The Monthly Project Report contained columns for customer name , project
26 number, contract amounts (total revenue dollars), amount of revenue recognized in the six preceding
27 months (identified by month), revenue to be recognized in the current month , and a 12-month forecast
28 of revenue available to be recognized (identified by month). Based on the comprehensive Monthly
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1 Project Report, G. Daou, D. Daou, McNeill and McGee would adjust upward the percent completion
2 for projects. According to CW1, who assisted in preparing the Monthly Project Report, after senior 3 management 's (G. Daou, D. Daou, McNeill, McGee) initial review of percentage of completion 4 estimates, he would be directed by Ringwall or Mirabile to make manual adjustments in the ManFact
5 system to increase the percentage of completion estimates submitted by project managers. 6 (e) CW1 further confirmed that Neil Cassidy, Vice President of Finance, and 7 Wayne Walker, a Project Analyst in the Accounting Department who worked for McGee, would
8 make jokes about the inflation of revenue recognition figures after defendants' review ofthe Monthly 9 Project Repo rt. Likewise, CW3, CW9, and CW 27 confirmed that G. Daou, D. Daou and McNeill 10 monitored the actual and reported progress on POC contracts and it was generally believed within 11 the Company that they were improperly recognizing revenue without regard to the actual status of 12 ongoing projects . 13 (f) CW9 confirmed G. Daou and D. Daou were active, day-to-day managers of 14 the Company and routinely met with McNeill and McGee . G. Daou maintained his own project 15 accounts, including Western Tennessee Healthcare System, Mercy Health Services and the Stanford 16 Medical Center . D. Daou oversaw mergers and acquisitions , using 6 .6 million shares of Daou's 17 artificially inflated stock to acquire 11 companies during the Class Period . CW4 further confirms that
18 the G. Daou, D . Daou and McNeill ran the day-to-day Field Services and Sales operations and 19 McGee ran the Accounting Depa rtment. 20 (g) G. Daou, D . Daou, McGee and Moragne each signed the Registration 21 Statement and Prospectus attesting to the information therein and their knowledge of and basis for
22 representing that Daou recognized revenue in line with its stated accounting policy and had 4Q96 23 revenue of $6 .95 million.
24 47. Defendants`false and misleading statements about Daou 's 1 Q97 accounting and
25 financial results:
26 (a) On April 21 , 1997, the Company issued a press release announcing its financial
27 results for first quarter ended March 31, 1997, reporting revenues of $5,204,(100, operating losses
28 of $500 ,000, accounts receivable of $3,372,000 and contract work in progress of $4,850,000 :
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1 First-quarter revenues for the period ending March 31, 1997, were $5.2 million, an increase of 123 percent over the $2.3 million reported for the first 2 quarter of 1996. The company reported a net loss of $232,000, or 2 cents per share . That compares with a net loss of $163,000, or 2 cents per share, for the same period 3 in 1996.
4 The increase in revenues was primarily attributable to the introduction of the company's information systems outsourcing services, which the company did 5 not provide in the first quarter of 1996, as well as an increase in network implementation revenues. 6 The Release quoted defendant G . Daou as stating: 7 "We are pleased with the progress we've made in implementing our 1997 8 corporate growth strategy," said Georges Daou, chief executive officer of DAOU Systems. 9 (b) Subsequent to the release of its 1 Q97 results, Daou held a conference call for 10 analysts, money and portfolio managers, institutional investors and large shareholders to discuss 11 Daou's I Q results, its business and its prospects. During the call, and in follow-up conversations with 12 analysts, G. Daou, D. Daou, McGee and McNeill stated: 13 • Daou's strong I Q results were due to the success of the Company's growth strategy 14 which had positioned the Company for strong growth going forward.
15 With its reorganization well underway, Daou was on track to achieve 1998 EPS of $0.42-$O.47. 16 17 (c) On or about April 23, 1997, Daou filed its report on Form I0-Q for the quarter ended March 31, 1997, signed by defendants D. Daou and McGee. This report contained the same 18 false financial information as was contained in the April 21, 1997 press release . Defendants 19 represented that "[t]hese financial statements reflect all adjustments, consisting of only normal 20 recurring adjustments which in the opinion of management, are necessary to fairly present the 21 financial position [of Daou] at March 31, 1997 . . . and 1996. 22 48. Reasons why defendants' I Q97 statements were false and misleading : Daou's 23 reported 1 Q97 financial results and earnings forecasts and defendants' statements attributing those 24 results and forecasts to "strong growth" and new services were false when made . The following 25 facts, corroborated by the accounts of at least 11 confidential witnesses, including accounting, 26 engineering and executive personnel who were based in Daou's San Diego headquarters and at 27 specific Company projects, confirm that, in truth, Daou's financial results and earnings forecasts were 28
-32- 98cv1537-L(CGA) E •
1 11 false and the result of defendants ' improper revenue recognition in violation of GAAP and Daou's 2 stated accounting policy:
3 (a) Defendants did not recognize revenue in accordance with POC accounting 4 requirements or Daou's stated accounting policy . POC accounting and GAAP require that revenue
5 not be recognized before it is earned and that all revenue recognized be based on the accurate
6 measure of the labor costs to date compared to the total estimated labor costs for the project . 7 According to CW5, a former engineer and assistant to one ofDaou's Field Services executives, durin g 8 1 Q97 revenue was recognized on Daou's contracts without regard to actual labor costs incurred or
9 projected. CW5, who dealt with accounting for ongoing contracts under defendant McNeill,
10 confirmed that defendants would automatically record 20% of the revenue from a contract upon
11 contract signing, prior to any labor costs being incurred . Forty percent of the revenue from contracts
12 was recognized immediately after any equipment was ordered and 50%-60% of the revenue was 13 recognized as soon as the equipment was "burned-in" (configured and tested) . CW5 confirmed that
14 this revenue was recognized without regard to labor costs incurred .
15 (b) CW28, a former senior network engineer and project manager, who worked
16 on Daou's Mercy Healthcare (Iowa) project in FY97, confirmed that a fixed amount of revenue was
17 recognized on contracts immediately upon signing, and that the revenue reported by defendants did
18 not reflect labor costs incurred compared to total estimated labor costs . Former Daou Sales
19 executive CW9 further confirmed the accuracy of CW5 and CW28 reports, and identified that during
20 this period defendants would recognize a fixed percentage of revenue immediately upon a contract 21 signing and upon ordering equipment, even when no labor costs were incurred.
22 (c) 1 Q97 revenue was artificially inflated to present the image of strong growth
23 and to boost Dacu's stock price . CW8, a Field Services Engineer during 1 Q97, and CW3, a Senior
24 Design Engineer during 1Q97 , both confirmed that it was known throughout Daou at this time that
25 G. Daou, D. Daou and McNeill were engaged in improper revenue recognition and that revenue on
26 POC contracts was being recognized prematurely (before labor costs were incurred). According to
27 CW3, CW5, CW9 and CW 28, this premature and improper revenue recognition - violating GAA.P
28
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1 and Daou's stated accounting policy -- was not limited to one or two contracts, but was true for all
2 or virtually all Daou projects, including the 1 Q97 Floyd Healthcare (Georgia) project . 3 (d) Had Daou reported revenue in line with the amount it was entitled to bill 4 customers pursuant to its contracts, actually reflecting contract work done to date, revenue would
5 have been only $4.1 million, 21% less than publicly reported ($5 .2 million). CW13, CW17 and 6 CW27 confirmed that the dramatic growth in Daou's work in progress account, increasing $1 . 1
7 million from 4Q96 to 1 Q97, was the result of defendants' premature recognition of revenue . The 8 work in progress account was comprised almost entirely of contract amounts Daou had recognized
9 as revenue but for which it was not entitled to bill because little or no labor had yet taken place and 10 the percentage of the project actually complete was lower than the percentage completion numbers 11 defendants used to calculate reported revenue . 12 (e) The reported increase in revenue during 1 Q97 was primarily attributable to
13 defendants' improper recognition of revenue, not "corporate growth" or new outsourcing services . 14 At least 21 % of Daou's publicly reported revenue was the result of prematurely recognizing revenue
15 without any basis in actual labor costs incurred or actual estimated total labor costs . 16 (f) Defendants' statements about Daou's 1 Q97 revenue were also false because,
17 in addition to the immediate recognition of revenue after a contract was signed or equipment wa s 18 ordered (and at a time when little or no labor costs had been incurred), defendants manipulated the
19 actual labor costs incurred and estimated total labor costs . According to CW12 and CW28, both
20 Field Services Engineers in FY97, the estimates of total labor costs provided by senior managers at 21 project sites were routinely ignored for revenue recognition purposes . The estimates of total labor 22 hours used to calculate revenue by defendants G. Daou, D. Daou, McNeill and McGee were, 23 according to CW 12, grossly understated and did not reflect the opinions of the on-site managers . 24 CW28 further confirmed that, during this period, he was told by Field Services Vice President 25 Mirabile, who worked at the direction of McNeill, what percent complete his projects were (for 26 revenue recognition purposes) and that these figures did not reflect the actual labor completed or
27 labor required to complete the projects . According to CW28, based on his firsthand knowledge fro m 28
-34- 98cv1537-L(CGA) 0 0
l Daou projects, the actual percentage of completion numbers were adjusted upward by Daou's senior 2 executives to boost reported revenue.
3 (g) CW2, a training manager based in Daou's headquarters during 1 Q97, reported 4 that he was specifically told by both a senior-level network engineer and a Field Services project 5 manager that defendants' revenue recognition on their projects was improper and was not based on
6 Daou's stated POC accounting policy . As a result, according to CW2, both the network engineer and
7 project manager left Daou after making their complaints about improper revenue recognition .
8 (h) Daou was not on track to achieve FY98 EPS of $0.42-$0.47 because 9 defendants were prematurely recognizing revenue, in violation of GAAP and the Company's stated
10 accounting policy, on contracts including the Floyd Healthcare (Georgia) and Atlantic Healthcare
11 projects, that would take at least two years to complete . As a result, according to CW3 and CW24, 12 project managers were told that projects were "closed" for billing purposes, when the projects were
13 actually far from completion . CW 17, a financial analyst in Daou's San Diego headquarters, confirmed 14 that, at the direction of McNeill, labor costs incurred after 100% of the revenue on the project was
15 recognized were dumped into accounts receivable . After defendants finally reported Daou's 16 disastrous 3Q98 results and revealed the financial impact of their accounting manipulations, Daou
17 reported a FY98 loss of $0.33 per share.
18 49 . Defendants' knowledge of falsity: Based on the reports of numerous witnesses, all
19 of whom were former members of Daou's Executive, Accounting or Field Services staff, defendants
20 not only knew that the Company's reported financial results and earnings forecast were based on
21 fraudulent accounting, but personally directed the violations of Daou's stated accounting policy and
22 GAAP in order to artificially inflate revenues :
23 (a) Defendants G. Daou, D. Daou, McNeill and McGee personally directed Daou's 24 recognition of revenue, financial reporting and public statements . Not only were these four 25 defendants the top executives at Daou, but, according to CW23, a former executive assistant to one
26 of the defendants, the Company was run "top to bottom" by G . Daou and D. Daou, with the 27 assistance of McNeill and McGee . G. Daou and D . Daou, confirmed CW23, were particularly 28
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1 concerned with the Company's revenue recognition and exceeding the Company's projected 1Q97
2 revenue and earnings and made the final decisions on POC accounting revenue to be recognized . 3 (b) CW 13 confirmed that McNeill provided G . Daou and D. Daou with all raw 4 POC and revenue recognition figures and, together with McGee, they personally determined what
5 revenue Daou would publicly report . According to CW5, who reported to McNeill, McNeill, 6 G. Daou and D. Daou paid particularly close attention to the POC and revenue recognition numbers, 7 and were, with McGee, the only people at Daou who could determine how much revenue to publicly 8 report. CW15 further confirmed that all decisions regarding recognition of revenue on Daou's
9 contracts were made by McNeill, G. Daou and D. Daou. 10 (c) CW9, a regional Sales Vice President at Daou, confirmed that defendants 11 G. Daou, D. Daou and McNeill not only made the decision on how much revenue to recognize 12 without regard to any actual percentage of completion, but directed the practice of automatically
13 recognizing revenue upon contract signing and ordering of equipment . Accordingly, from their own 14 actions, these defendants knew their statements about Daou' accounting policy and revenue
15 recognition were false and misleading when made.
16 (d) All of the defendants knew how Daou's results were progressing in 1Q97 and
17 knew that the reported revenue could only be achieved by manipulating the Company's financial
18 results. CW1, CW5, CW7, CW12, CW17 and CW21 all confirm that both actual labor costs
19 incurred/completed and the estimates used to falsify Daou's revenue recognition were recorded under
20 the direction of McNeill and distributed to G . Daou, D. Daou, McGee and, periodically, to directors
21 including Moragne . Each employee on a Daou project was provided with a workbook containing the
22 template for an Excel spreadsheet . The spreadsheet (the job costing sheet) contained categories for
23 hours worked, along with travel and non-billable time . For each time period (initially Sunday to
24 Sunday, later changed to bi-weekly), the spreadsheet was provided to the project manager . The 25 project manager would compile the billable time, make an estimate, based on the time and costs
26 incurred to date of the percent of the project that was complete, and e-mail the information to Daou's
27 project cost accounting staff in San Diego, who operated under COO McNeill . CWI, a project cost
28 analyst, stated that the time and percentage of completion data was entered into the Company' s
-36- 98cv1537-L(CGA) 0 •
ManFact accounting system. One or two days before the end ofthe month, Vice Presidents Ringwall and Mirabile would print out the ManFact reports containing actual labor and percent completion submitted by project managers, for the current month and quarter. According to CW3, CW4, CW7 and CW16, the ManFact data was compiled into a Monthly Project Report which was sent to
G. Daou, D. Daou, McGee, and McNeill at the close of each month and quarter. The Monthly Project Report contained columns for customer name, project number, contract amounts (total revenue dollars), amount of revenue recognized in the six preceding months (identified by month), revenue to be recognized in the current month, and a 12-month forecast of revenue available to be
9 recognized (identified by month) . Based on the comprehensive Monthly Project Report, G . Daou,
10 D. Daou, McNeill and McGee would adjust upward the percent completion for projects . According
11 to CWI, who assisted in preparing the Monthly Project Report, after senior management's (G. Daou,
12 D. Daou, McNeill, McGee) initial review of percentage of completion estimates, he would be directed
13 by Ringwall or Mirabile to make manual adjustments in the ManFact system to increase the
14 percentage of completion estimates submitted by project managers .
15 (e) CWI further confirmed that Vice President Neil Cassidy and Project Analyst
16 Wayne Walker would routinely make jokes about the inflation of revenue recognition figures after
17 defendants ' review of the Monthly Project Report. Likewise, CW3, CW9 and CW27 confirmed that 18 G. Daou, D. Daou and McNeill monitored the actual and reported progress on POC contracts and
1 9 it was generally believed within the Company that they were improperly recognizing revenue without 20 regard to the actual status of ongoing projects. 21 (f) CW9 confirmed G . Daou and D . Daou were active, day-to-day managers o f
22 the Company and routinely met with McNeill and McGee . G. Daou maintained his own project
23 accounts, including Western Tennessee Healthcare System, Mercy Health Services and the Stanford 24 Medical Center . D. Daou oversaw mergers and acquisitions, using 6,6 million shares of Daou's
25 artificially inflated stock to acquire 11 companies during the Class Period . CW4 further confirms that
26 the G. Daou, D. Daou and McNeill ran the day-to-day Field Services and Sales operations and 27 McGee ran the Accounting Department .
28 1
-37- 98cv 1537-L(CGA) 1 (g) During the conference call and subsequent conversations with analysts and
2 money and portfolio managers, defendants G . Daou, D. Daou, McGee and McNeill presented 3 themselves as the persons at Daou most knowledgeable about the Company's reported revenue, 4 earnings expectations, financial results and business . CW14, a former analyst who covered Daou,
5 confirmed that these defendants, and in particular McGee, presented themselves as knowledgeabl e
6 about all aspects of the Company's finances, including earnings and revenue recognized under PO C 7 I accounting.
8 (h) D. Daou and McGee signed the report on Form 10-Q for 1 Q97 attesting to
9 the information therein and their knowledge of and basis for representing that Daou recognized
10 ,revenue in line with its stated policy and had 1 Q97 revenue of $5 .2 million.
11 50. Defendants 'false and misleading statements about Daou 's 2Q97 accounting and
12 financial results:
13 (a) On July 16, 1997, through the Business Wire, the Company announced its
14 financial results for the second quarter ended June 30, 1997, reporting revenues of $6,004,000,
15 1 operating losses of $112,000, accounts receivable of $5,593,000 and contract work in progress of
16 $5,297,000:
17 The company posted second-quarter andyear-to-date revenue of $6 million and $11.2 million respectively, increases over the previousyear of I5percent and 18 49 percent respectively. Net income for the second quarter was $58,000 with a net loss for the year to date of $174,000 . 1 9 That translates to second-quarter earnings per share of 1 cent, the same as 20 for the second quarter of the previous year . The year-to-date earnings per share are a loss of 2 cents, which compares with a loss of 1 cent for the same period in 1996 . 21 The increase in revenue is primarily attributable to an increase in the 22 number of network management and implementation contracts that the company has secured with such major health care organizations as Harris Methodist Health 23 System, Centura Health and St Mary 's Health Network. 24 These and other management contracts have boosted the company's recurring revenue to 33 percent for the year to date. 25 26 "We are continuing to roll out our corporate strategy, "said Georges Daou, 27 chief executive officer of DAOU Systems. "All our planned regional offices have been established within the past 120 days and are productive." 28
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1 (b) On or about July 16, 1997, Daou filed its report on Form 10-Q for the quarter
2 ended June 30, 1997, signed by defendants D . Daou and McGee. This report contained the same
3 false financial information as was contained in the July 16, 1997 press release . Defendants 4 represented that "[t]hese financial statements reflect all adjustments, consisting of only normal 5 recurring adjustments which in the opinion of management, are necessary to fairly present the 6 financial position [of Daou] at June 30, 1997 and 1996."
7 (c) Subsequent to the release of its 2Q97 results, Daou held a conference call for 8 analysts, money and portfolio managers, institutional investors and large shareholders to discuss 9 Daou's 2Q results, its business and its prospects . During the call - and in follow-up conversations 10 with analysts - G . Daou, D. Daou, McGee and McNeill stated: 11 Daou's better than expected 2Q results were due to strong business momentum in 12 developing new business .
13 Daou's days sales outstanding (the measure ofthe estimated time to collect receivables
14 ("DSO")) had increased to 89 days but this was due to more billing activity in June 1997
15 and not due to any problems.
16 Daou was on track to achieve 1998 EPS of $0.42-$0.60. 17 Contract work-in-progress totaled $6 .25 million, but $4.4 million of that total was 18 hardware purchased for which no revenue had been recognized .
19 51 . Reasons why defendants' 2Q97 statements were false and misleading: Daou's
20 reported 2Q97 financial results and its earnings forecasts and statements attributing those results and
21 forecasts to increased contracts and strong business momentum were false when made. The
22 following facts, corroborated by the accounts of at least 12 confidential witnesses, including
23 accounting, engineering and executive personnel who were based in Daou's San Diego headquarters
24 and at specific Company projects, confirm that, in truth, Daou's financial results and earnings
25 forecasts were false and the result of defendants' improper revenue recognition in violation of GAAP
26 and Daou's stated accounting policy.
27 (a) Defendants did not recognize revenue in accordance with POC accounting
28 requirements or Daou's stated accounting policy . POC accounting and GAAP require that revenue
-39- 98cv1537-L(CGA) I not be recognized before it is earned and that all revenue recognized be based on the accurate 2 measure of the labor costs to date compared to the total estimated labor costs for the project . 3 According to CW5, a former engineer and assistant to one ofDaou's Field Services executives, during 4 2Q97 revenue was recognized on Daou's contracts without regard to actual labor costs incurred or 5 projected. CWS, who dealt with accounting for ongoing contracts under defendant McNeill,
6 confirmed that defendants would automatically record 20% of the revenue from a contract upon 7 contract signing, prior to any labor costs being incurred . Forty percent of the revenue from contracts 8 was recognized immediately after any equipment was ordered, and 50%-60% of the revenue was 9 recognized as soon as the equipment was "burned-in" (configured and tested) . CW5 confirmed that 10 this revenue was recognized without regard to labor costs incurred . 11 (b) CW28, a former senior network engineer and project manager, who worked
12 on Daou's Mercy Health Services project, confirmed that a fixed amount of revenue was recognized 13 on contracts immediately upon signing, and that the revenue reported by defendants did not reflect 14 labor costs incurred compared to total estimated labor costs . Former Daou Sales executive CW9 15 further confirmed the accuracy of CW5 and CW28's reports, and stated that during this period 16 defendants would recognize a fixed percentage ofrevenue upon a contract signing and upon ordering 17 equipment, even when no labor costs were incurred. 18 (c) 2Q97 revenue was artificially inflated to present the image of strong growth
19 and boost Daou's stock price . CW8, a Field Services Engineer during 2Q97, and CW3, a senior 20 Design Engineer during 2Q97, both confirmed that it was known throughout Daou at this time that 21 G. Daou, D. Daou and McNeill were engaged in improper revenue recognition and that revenue on 22 POC contracts was being recognized prematurely (before labor costs were incurred) . According to 23 CW3, CW5, CW9 and CW28, this premature and improper revenue recognition - violating GAAP 24 and Daou's stated accounting policy - was not limited to one or two contracts, but was true for all 25 or virtually all Daou projects, including the 2Q97 Mercy Health Services project . 26 (d) Had Daou reported revenue in line with the amount it was entitled to bill 27 customers pursuant to its contracts, actually reflecting contract work done to date, revenue would 28 have been only $5 .5 million, 9% less than publicly reported ($6 .0 million). CW13, CW17 and CW2 7
-40- 98cv1537-L(CGA) 0 9
1 confirmed that the dramatic growth in Daou's work in progress account, increasing $447,000 from
2 1 Q97 to 2Q97, was the result ofdefendants' premature recognition of revenue . The work in progress 3 account was comprised almost entirely of contract amounts Daou had recognized as revenue but for 4 which it was not entitled to bill because little or no labor had yet taken place and the percentage of 5 the project actually complete was lower than the percentage completion numbers defendants used to 6 calculate reported revenue.
7 (e) The reported increase in revenue during 2Q97 was primarily attributable to 8 defendants' improper recognition of revenue, not "increased contracts" and "strong business 9 momentum." At least 9% ofDaou's publicly reported revenue, representing nearly all of the increase 10 from Daou's 2Q96, was the result of prematurely recognizing revenue without any basis in actual 1 l labor costs incurred or actual total labor costs estimated .
12 (f) Revenue on Daou's Centura Health project was recognized in 2Q97 when no
13 actual labor costs were incurreds According to CW5, who worked with Daou's Field Services
14 executives (including McNeill and Mirabile), in late June 1997 Daou was struggling to make its
15 projected 2Q97 earnings and revenue numbers . In the last week of June, Vice President of Field
16 Services, Mirabile, at G. Daou's direction, directed CW5 to find a new project with equipment in
17 Daou's San Diego warehouse. At the request of G . Daou, three Field Services employees (salaried)
18 were offered $100 each to come in on the last Saturday in June 1997, unpack and plug in computer
19 equipment ordered for the Centura Health project and immediately record 8 hours of labor each on
20 their job costing sheets. According to CW5, the purpose of this deceptive practice was to justify
21 recognizing 30%-40% of the revenue on the Centura Health project in 2Q97 .
22 (g) CW8 corroborated CW5's account of defendants' improper recognition of
23 revenue on the Centura Health project in 2Q97 . According to CW8, he and two or three other Field
24 Services engineers were directed by Mirabile, at the request of McNeill or G . Daou, to go to Daou's
25 San Diego warehouse, plug in some computers, turn them on and leave . CW8 says he and the other
26 Field Services personnel were told to bill eight hours each to the Centura Health project, just for
27 plugging in and turning on the computers, and were promised $100 each for doing so. CW8 further
28 stated that he was never paid the $100 and when he followed up about the payment with Mirabile' s
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1 assistant, he was told to "forget about it" and "forget it ever happened ." According to CW8, the only 2 rationale for the request that he and others bill eight hours work for no real labor was to prematurely 3 recognize revenue on the Centura Health project .
4 (h) Defendants' statements about Daou's 2Q97 revenue were also false because, 5 in addition to the immediate recognition of revenue after a contract was signed or equipment was
6 ordered (and at a time when little or no labor costs had been incurred), defendants manipulated the 7 actual labor costs incurred and estimated total labor costs . According to CW28 and CWI2, both 8 Field Services Engineers in FY97, the estimates of total labor costs provided by senior managers at 9 project sites were routinely ignored for revenue recognition purposes . The estimates of total labor
10 hours used to calculate revenue by defendants G . Daou, D. Daou, McNeill and McGee were, 11 according to CW 12, grossly understated and did not reflect the opinions of the on-site managers . 12 CW28 further confirms that, during this period, he was told by Field Services Vice President Mirabile,
13 who worked at the direction of McNeill, what percent complete his projects were (for revenue 14 recognition purposes) and that these figures did not reflect the actual labor completed or labor 15 required to complete the projects . According to CW28, based on his firsthand knowledge from Daou 16 projects, the actual percentage of completion numbers were adjusted upward by Daou's senior 17 executives to boost reported revenue . 18 (i) Daou was not on track to achieve FY98 EPS of $0 .42-$0.47 because 19 defendants were prematurely recognizing revenue, in violation of GAAP and the Company's stated 20 accounting policy, on contracts including the Centura Health project, that would take over a year to 21 complete. As a result, according to CW3 and CW24, project managers were told that projects were 22 "closed" for billing purposes, when the projects were actually far from completion . CW 17, a financial 23 analyst in Daou's San Diego headquarters, confirmed that, at the direction of McNeill, labor costs 24 incurred after 100% of the revenue on the project was recognized were dumped into accounts 25 receivable. After defendants finally reported Daou's disastrous 3 Q98 results and revealed the financial 26 impact of their accounting manipulations, Daou reported a FY98 loss of $0 .33 per share . 27 (j) CW2, a training manager based in Daou's headquarters during 2Q97, reported 28 that he was specifically told by both a senior-level network engineer and a Field Services projec t
-42- 98cv1537-L(CGA) 0 •
1 manager that defendants' revenue recognition on their projects was improper and was not based on
2 Daou's stated POC accounting policy . As a result, according to CW2, both the network engineer and
3 project manager left Daou after making their complaints about improper revenue recognition. 4 (k) Daou's work in progress account was primarily unbilled receivables, not
5 hardware purchases for which no revenue had been recognized . CW4 and CW5 both confirm that 6 Daou recognized a fixed percentage of revenue immediately upon ordering and receiving equipment
7 for a project. CW 13 and CW 17, as detailed above, further confirmed that the work in progress 8 account was comprised almost entirely of contract amounts Daou had recognized as revenue but for 9 which it was not entitled to bill because little or no labor had yet taken place and the percentage of
10 the project actually complete was lower than the percentage completion numbers defendants used to 11 calculate reported revenue.
12 52. Defendants' knowledge of falsity : Based on the reports of numerous witnesses, all 13 of whom are former members of Daou's Executive, Accounting or Field Services staff, defendants 14 not only knew that the Company's reported financial results and earnings forecast for 2Q97 were 15 based on fraudulent accounting, but personally directed the violations of Daou's stated accounting 16 policy and GAAP in order to artificially inflate revenues .
17 (a) Defendants G. Daou, D. Daou, McNeill and McGee personally directed Daou's
18 recognition of revenue, financial reporting and public statements . Not only were these four
19 defendants the top executives at Daou but, according to CW23, a former executive assistant to one
20 of the defendants, the Company was run "top to bottom" by G . Daou and D. Daou, with the
21 assistance of McNeill and McGee . G. Daou and D. Daou, confirmed CW23, were particularly
22 concerned with the Company's revenue recognition and exceeding the Company's projected 2Q97
23 revenue and earnings, and made the final decisions on POC accounting revenue to be recognized .
24 (b) CW 13 confirmed that McNeill provided G. Daou and D. Daou with all raw 25 POC, and revenue recognition figures and, together with McGee, they personally determined what
26 revenue Daou would publicly report . According to CW5, who reported to McNeill, McNeill,
27 G. Daou and D. Daou paid particularly close attention to the POC and revenue recognition numbers,
28 and were, with McGee, the only people at Daou who could determine how much revenue to publicly
-43- 98cvl537-L(CGA) I report. CW15 further confirmed that all decisions regarding recognition of revenue on Daou's 2 contracts were made by McNeill, G. Daou and D . Daou. 3 (c) CW9, a regional Sales Vice President at Daou, confirmed that defendants 4 G. Daou, D. Daou and McNeill not only made the decision on how much revenue to recognize 5 without regard to any actual percentage of completion, but directed the practice of automatically
6 recognizing revenue upon contract signing and ordering of equipment . Accordingly, from their own 7 actions, these defendants knew their statements about Daou' accounting policy and revenue 8 recognition were false and misleading when made .
9 (d) Defendants knew that Daou had prematurely recognized 100% of the revenue
10 on projects that were not near completion. Between 1 Q97 and 2Q97, Daou's accounts receivable,
11 which defendants publicly reported and were aware of, increased $2 .2 million. According to CW17,
12 a former financial analyst at Daou, defendants knew that the accounts receivable balance at Daou
13 represented labor costs incurred on a project after 100% of the revenue had been recognized under
14 POC accounting. CW 13 confirmed that defendants' premature recognition of 100% of the revenue
15 on contracts resulted in continuing labor costs being allocated to accounts receivable .
16 (e) As described above, Daou's reported 2Q97 revenue was artificially inflated by
17 the recognition of 30%-40% of the revenue on the Company's Centura Health project when no real
18 labor costs had been incurred and the project was not 30%-40% complete . According to CW5, who
19 had personal knowledge of the Centura Health account, defendants G . Daou and McNeill knew of
20 and directed Field Services engineers to falsely bill labor hours to the Centura Health project in order
21 to justify the premature recognition of revenue and inflate Daou's 2Q97 revenue .
22 (0 All of the defendants knew how Daou's results were progressing in 2Q97 and
23 knew that the reported revenue could only be achieved by manipulating the Company's financial
24 results. CW 1,CW5, CW7, CW12, CW 17 and CW21 all confirm that both actual labor costs
25 incurred/completed and the estimates used to falsify Daou's revenue recognition were recorded under
26 the direction of McNeill and distributed to G . Daou, D. Daou, McGee and, periodically, to directors,
27 including Moragne . Each employee on a Daou project was provided with a workbook containing the
28 template for an Excel spreadsheet . The spreadsheet (the job costing sheet) contained categories fo r
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1 hours worked, along with travel and non-billable time . For each time period (initially Sunday to
2 Sunday, later changed to bi-weekly), the spreadsheet was provided to the project manager . The 3 project manager would compile the billable time, make an estimate, based on the time and costs
4 incurred to date, of the percent of the project that was complete and e-mail the information to Daou's
5 project cost accounting staff in San Diego, who operated under COO McNeill . CW 1, a project cost 6 analyst, stated that the time and percentage of completion data were entered into the Company's
7 ManFact accounting system. One or two days before the end of the month, Vice Presidents Ringwall 8 and Mirabile would print out the ManFact reports containing actual labor and percent completion 9 submitted by project managers for the current month and quarter . According to CWI, CW3, CW4,
10 CW7 and CWl6, the ManFact data was compiled into a Monthly Project Report which was sent to 11 G. Daou, D. Daou, McGee and McNeill at the close of each month and quarter . The Monthly Project 11 12 Report contained columns for customer name, project number, contract amounts (total revenue 13 dollars), amount of revenue recognized in the six preceding months (identified by month), revenue 14 to be recognized in the current month, and a 12-month forecast ofrevenue available to be recognized 15 (identified by month) . Based on the comprehensive Monthly Project Report, G . Daou, D. Daou, 16 McNeill and McGee would adjust upward the percent completion for projects . According to CW 1, 17 who assisted in preparing the Monthly Project Report, after senior management's (G . Daou, D. Daou, 18 McNeill, McGee) initial review of percentage of completion estimates, he would be directed by 19 Ringwall or Mirabile to make manual adjustments in the ManFact system to increase the percentage
20 of completion estimates submitted by project managers .
21 (g) CW1 further confirmed that Vice President Neil Cassidy and Project Analyst
22 Wayne Walker would make jokes about the inflation of revenue recognition figures after defendants'
23 review of the Monthly Project Report. Likewise, CW3, CW9 and CW27 confirmed that G. Daou,
24 D. Daou and McNeill monitored the actual and reported progress on POC contracts and it was
25 generally believed within the Company that they were improperly recognizing revenue without regard
26 to the actual status of ongoing projects.
27 (h) CW9 confirmed G. Daou and D. Daou were active, day-to-day managers of 28 the Company and routinely met with McNeill and McGee. G. Daou maintained his own project
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1 accounts, including Western Tennessee Healthcare System, Mercy Health Services and the Stanford
2 Medical Center . D. Daou oversaw mergers and acquisitions, using 6 .6 million shares of Daou's 3 artificially inflated stock to acquire 11 companies during the Class Period . CW4 further confirms that 4 G. Daou, D. Daou and McNeill ran the day-to-day Field Services and Sales operations and McGee 5 ran the Accounting Department .
6 (i) During the conference call and subsequent conversations with analysts and
7 money and portfolio managers, defendants G . Daou, D. Daou, McGee and McNeill presented 8 themselves as the persons at Daou most knowledgeable about the Company's reported revenue, 9 earnings expectations, financial results and business . CW14, a former analyst who covered Daou,
10 confirmed that these defendants, and in particular McGee, presented themselves as knowledgeable 11 about all aspects of the Company's finances, including earnings and revenue recognized under POC 12 accounting.
13 (j) At the same time as defendants were making their positive, albeit false
14 statements about Daou's 2Q97 financial results and business prospects, defendants, led by D . Daou,
15 acquired INTEGREX Systems Corp. in exchange for 700,000 shares of stock valued at the time at
16 $11 .4 million.
17 (k) Within three weeks of making their positive statements about Daou's 2Q97
18 financial results and business prospects, defendants D . Daou, G. Daou, McGee and Moragne sold 19 $1 .29 million shares of their personal Daou stock to an unsuspecting public, pocketing $25 million. 20 (1) D. Daou and McGee signed the report on Form 10-Q for 2Q97 attesting to 21 the information therein and their knowledge of and basis for representing that Daou recognized 22 revenue in line with its stated policy and that it had 2Q97 revenue of $6 .0 million.
23 53. On August 15, 1997, the Company filed a Registration Statement and Prospectus for
24 an offering of 2,365,000 shares of the Company's common stock, 1,865,000 shares of which were
25 being offered by certain insiders including the Individual Defendants . In the Registration Statement
26 and Prospectus issued in connection with the offering, defendants again represented that Daou
27 typically provided its services on a fixed fee basis and that the Company recognized revenue using
28 the POC method :
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I Contract revenue for the development and implementation of network solutions is recognized on the percentage-of-completion method with progress to 2 completion measured by labor costs incurred to date compared to total estimated labor costs. Provisions for the estimated losses on contracts, if any, are made during 3 the period when the loss becomes probable and can be reasonably estimated . Revenues recognized in excess of amounts billed and project costs are classified as 4 contract work in progress . 5 The Prospectus also contained Daou's false financial results for the first six months of 1997 . 6 54 . Defendants' statements in the Prospectus were, again, false and misleading because, 7 as described with regard to Daou's February 13, 1997 Prospectus and 1Q97 and 2Q97 accounting 8 and financial results, defendants did not comply with Daou's stated accounting policy and improperly 9 recognized revenues utilizing the POC methodology in violation of GAAP . The Registration
10 Statement was signed by D . Daou and McGee, who, as described with regard to Daou's 1 Q97 %48- 11 49 and 2Q97 statements' 151-52, knew their statements were false and misleading when made . 12 55. The insiders who dumped thousand of shares in this offering and reaped millions of 13 dollars included defendants G. Daou, D. Daou, McGee, and Moragne, who sold shares for more than 14 $25 million. Specifically, G. Daou and D . Daou each sold 479,937 shares, McGee sold 12,600 shares 15 and entities controlled by Moragne sold 316,836 shares . 16 56, In September 1997, with Daou stock trading at artificially inflated prices as a result
17 of defendants' false and misleading statements, defendants, led by D . Daou, acquired On-Line 18 Networking, Inc . in exchange for 150,000 shares of stock valued at $5,000,000 . 19 57. Defendants' false and misleading statements about Daou 's 3Q97 accounting and 20 financial results:
21 (a) On October 15, 1997, through the Business Wire, the Company announced
22 record revenue and earnings for the third quarter of fiscal year 1997, reporting revenues of
23 $11,299,000, operating income of $66,000, accounts receivable of $6,294,000 and contract work in
24 progress of $10,737,000 :
25 The company posted third-quarter and year-to-date revenue of $11.3 million and $27.2 million respectively, increases over the previous year of 61 26 percent and 41 percent respectively . Net income, fully taxed before one-time merge r and tax-related costs for the third quarter, was $578,000, with a net income for the 27 year to date of $488,000 . That translates to third-quarter earnings per share of S cents, an increase of 2 cents per share over the third quarter of the previous year . The 28 year-to-date earnings per share are 4 cents , which compares to 6 cents for the same period in 1996 .
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1 The increase in revenue is primarily attributable to the growth and success of DAOU's national sales and marketing strategy, the introduction ofnew services and 2 the continued market demand forthe company's core technology. The firm's client base has grown to more than 600 organizations . 3 * * * 4 "Our strategy is unfolding as planned," said Georges Daou, chief executive 5 officer of DAOU Systems . "New services such as our desktop support contract with Harris Methodist Health System in Dallas have been well received by the market . 6 Our core business continues to grow, as is illustrated by our major network design and implementation project at Centura Health, which is Colorado's largest healthcare 7 organization. And our merger with INTEGREX is leading to new projects as healthcare organizations seek to integrate voice, video and data networks . " 8 (b) Subsequent to the release of its 3Q97 results, Daou held a conference call for 9 analysts, money and portfolio managers, institutional investors and large shareholders to discuss 10 Daou's 3Q results, its business and its prospects. During the call - and in follow-up conversations 11 with analysts - G . Daou, D. Daou, McGee and McNeill stated : 12 • Daou 's results had well exceeded analyst estimates because Daou was continuing 13 to sign new contracts and business momentum was exceptional. 14 • Daou was on track to report increased EPS of $0 SO-$0.62 in 1998. 15 These statements had a dramatic impact on the Company's stock price . On the day following the 16 announcement, the Company's stock price jumped nearly $3 to close at $28-1/8 . 17 (c) On or about November 4, 1997, Daou filed its report on Form 10-Q for the 18 quarter ended September 30, 1997, signed by defendants D. Daou and McGee. This report contained 19 the same false financial information as was contained in the October 15, 1997 press release . 20 Defendants represented that '"[t]hese financial statements reflect all adjustments, consisting of only 21 normal recurring adjustments which in the opinion of management, are necessary to fairly present the 22 financial position [of Daou] at September 30, 1997 and the results of operations for the three and 23 nine-month periods ended September 30, 1997 and 1996 ." 24 58. Reasons why defendants' 3Q97 statements were false and misleading: Daou's 25 reported 3Q97 financial results and earnings forecasts, claims of dramatic year-to-year revenue 26 growth and statements attributing the Company's "success" to exceptional business growth were false 27 28 and misleading when made . The following facts, corroborated by the accounts of at least 15
confidential witnesses, including accounting, engineering and executive personnel who were base d
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1 in Daou's San Diego headquarters and at specific Company projects, confirm that, in truth, Daou's 2 financial results and earnings forecasts were false and misleading and the result of defendants' 3 improper revenue recognition in violation of GAAP and Daou's stated accounting policies, not
4 exceptional business growth or Company success . 5 (a) Defendants did not recognize revenue in accordance with POC accounting
6 requirements or Daou's stated accounting policy . POC accounting and GAAP require that revenue 7 not be recognized before it is earned and that all revenue recognized be based on the accurate
8 measure of the labor costs to date compared to the total estimated labor costs for the project . 9 According to CW5, a former engineer and assistant to one ofDaou's Field Services executives, during
10 3Q97 revenue was recognized on Daou's contracts without regard to actual labor costs incurred or 11 projected. CW5, who dealt with accounting for ongoing contracts under defendant McNeill, 12 confirmed that defendants would automatically record 20% of the revenue from a contract upon
13 contract signing, prior to any labor costs being incurred. Forty percent ofthe revenue from contracts 14 was recognized immediately after any equipment was ordered, and 50%-60% of the revenue was 15 recognized as soon as the equipment was "burned-in" (configured and tested) . CW5 confirmed that 16 this revenue was recognized without regard to labor costs incurred .
17 (b) CW28, a former senior network engineer and project manager, who worked
18 on Daou's Mercy Health Services project, confirmed that a fixed amount of revenue was recognized
19 on contracts immediately upon signing, and that the revenue reported by defendants did not reflect
20 labor costs incurred compared to total estimated labor costs . Former Daou Sales executive CW9
21 further confirmed the accuracy of CW5 and CW28's reports, and stated that during this period
22 defendants would recognize a fixed percentage of revenue upon a contract signing and upon ordering
23 equipment, even when no labor costs were incurred.
24 (c) 3Q97 revenue was artificially inflated to present the image of strong growth
25 and boost Daou's stock price . CW8, a Field Services Engineer during 3Q97, and CW3, a senior
26 Design Engineer during 3Q97, both confirmed that it was known throughout Daou at this time that
27 G. Daou, D. Daou and McNeill were engaged in improper revenue recognition and that revenue on
28 POC contracts was being recognized prematurely (before labor costs were incurred) . According to
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1 CW3, CW5, CW9 and CW28, this premature and improper revenue recognition - violating GAAP
2 and Daou's stated accounting policy - was not limited to one or two contracts, but was true for all
3 or virtually all Daou projects.
4 (d) Had Daou reported revenue in line with the amount it was entitled to bill 5 customers pursuant to its contracts, actually reflecting contract work done to date, revenue for 3 Q97 6 would have been only $5.9 million, 48% less than publicly reported ($11 .3 million). CW 13, CW 17 7 and CW27 confirmed that the dramatic growth in Daou's work in progress account, increasing $5 .4 8 million from 2Q97 to 3Q97, was the result of defendants' premature recognition of revenue . The
9 work in progress account was comprised almost entirely of contract amounts Daou had recognized 10 as revenue but for which it was not entitled to bill because little or no labor had yet taken place and 11 the percentage of the project actually complete was lower than the percentage completion numbers
12 defendants used to calculate reported revenue . 13 (e) The reported increase in revenue during 3Q97 was attributable to defendants' 14 improper recognition ofrevenue, not "corporate growth" or new outsourcing services . At least 48% 15 of Daou's publicly reported revenue, representing the entire amount of increased revenue from 2Q97, 16 was the result of prematurely recognizing revenue without any basis in actual labor costs incurred or
17 actual total estimated labor costs .
18 (0 Business was not growing or exceptional, and the Centura Health project was
19 losing money. According to CW 10, a former account manager for the Centura Health project, Daou
20 was losing money on the Centura Health account as a result of recognizing revenue before labor costs
21 were actually incurred . As detailed under 2Q97, CW5 and CW8 both described how defendants
22 recognized 30%-40% of the revenue from the Centura Health contract in 2Q97 based on no more
23 than false records of hours worked and plugging in and turning on computers destined for the project .
24 (g) CW5 confirmed that, as in 2Q97, during the final weeks of the 3Q97,
25 defendants were desperate to report revenue growth . At the time, according to CW5, Daou, led by
26 G. Daou, was in the process of negotiating a multimillion contract with Candler Health Systems .
27 During the final days of 3Q97, all of the equipment for the Candler Health Systems project was
28 ordered and Daou immediately recognized 20% of the contract price, approximately $1-1 .5 million,
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1 as revenue, before any contract was signed. By the following quarter, after the Candler Health 2 Systems project revenue had been reported, Daou still did not have a contract and had incurred no
3 actual labor costs . Daou never received the contract and eventually was forced to sell the equipment 4 at a loss. 5 (h) Defendants' statements about Daou's accounting policy and 3Q97 revenue 6 were also false because, in addition to the immediate recognition of revenue after a contract was 7 signed or equipment was ordered (and at a time when little or no labor costs had been incurred),
8 defendants manipulated the actual labor costs incurred and estimated total labor costs . According 9 to CW12 and CW28, both Field Services Engineers in FY97, the estimates of total labor costs
10 provided by senior managers at project sites were routinely ignored for revenue recognition purposes . 11 The estimates of total labor hours used to calculate revenue by defendants G . Daou, D. Daou, 12 McNeill and McGee were, according to CW 12, grossly understated and did not reflect the opinions
13 of the on-site managers . CW28 further confirms that, during this period, he was told by Field 14 Services Vice President Mirabile, who worked at the direction of McNeill, what percent complete 15 his projects were (for revenue recognition purposes) and that these figures did not reflect the actual 16 labor completed or labor required to complete the projects. According to CW28, based on his 17 firsthand knowledge from Daou projects, the actual percentage of completion numbers were adjusted
18 upward by Daou's senior executives to boost reported revenue .
19 (i) Daou was not on track to achieve FY98 EPS of $0 .50-$0.62 because
20 defendants were prematurely recognizing revenue, in violation of GAAP and the Company's stated
21 accounting policy, on contracts including the Candler Health Systems project, that would take over
22 one year to complete. As a result, according to CW3 and CW24, project managers were told that
23 projects were "closed" for billing purposes, when the projects were actually far from completion .
24 CW17, a financial analyst in Daou's San Diego headquarters, confirmed that, at the direction of
25 McNeill, labor costs incurred after 100% of the revenue on the project was recognized were dumped
26 into accounts receivable. After defendants finally reported Daou's disastrous 3Q98 results and
27 revealed the financial impact of their accounting manipulations, Daou reported a FY98 loss of $0 .33
28 per share.
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1 (j) CW2, a training manager based in Daou's headquarters during 3Q97, reported
2 that he was specifically told by both a senior-level network engineer and a Field Services project 3 manager that defendants' revenue recognition on their projects was improper and was not based on 4 Daou's stated POC accounting policy . As a result, according to CW2, both the network engineer and 5 project manager left Daou after making their complaints about improper revenue recognition. 6 (k) Daou's work in progress account was primarily unbilled receivables, not
7 hardware purchases for which no revenue had been recognized . CW4 and CW5 both confirm that 8 Daou recognized a fixed percentage of revenue immediately upon ordering and receiving equipment
9 for a project. CW 13 and CW 17, as detailed above, further confirmed that the work in progress 10 account was comprised almost entirely of contract amounts Daou had recognized as revenue but for I 1 which it was not entitled to bill because little or no labor had yet taken place and the percentage of 12 the project actually complete was lower than the percentage completion numbers defendants used to
13 calculate reported revenue. 14 59 . Defendants' knowledge of falsity: Based on the reports of numerous witnesses, all 15 of whom are former members of Daou's Executive, Accounting or Field Services staff, defendants 16 not only knew that the Company's reported financial results and earnings forecasts were based on 17 fraudulent accounting, but personally directed the violations of Daou's stated accounting policy and
18 GAAP in order to artificially inflate revenues:
19 (a) Defendants G. Daou, D. Daou, McNeill and McGee personally directed Daou's
20 recognition of revenue, financial reporting and public statements . Not only were these four
21 defendants the top executives at Daou, but, according to CW23, a former executive assistant to one
22 of the defendants, the Company was run "top to bottom" by G. Daou and D . Daou, with the
23 assistance of McNeill and McGee . G. Daou and D . Daou, confirmed CW23, were particularly
24 concerned with the Company's revenue recognition and exceeding the Company's projected revenue
25 and earnings, and made the final decisions on POC accounting revenue to be recognized .
26 (b) CW I3 confirmed that McNeill provided G. Daou and D. Daou with all raw
27 POC and revenue recognition figures and that, together with McGee, they personally determined
28 what revenue Daou would publicly report . According to CW5, who reported to McNeill, McNeill ,
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I G. Daou and D. Daou paid particularly close attention to the POC and revenue recognition numbers, 2 and were, with McGee, the only people at Daou who could determine how much revenue to publicly 3 report. CW15 further confirmed that all decisions regarding recognition of revenue on Daou's 4 contracts were made by McNeill, G. Daou and D . Daou. 5 (c) CW9, a regional Sales Vice President at Daou, confirmed that defendants G .
6 Daou, D. Daou and McNeill not only made the decision on how much revenue to recognize without 7 regard to any actual percentage of completion, but directed the practice of automatically recognizing 8 revenue upon contract signing and ordering of equipment . Accordingly, from their own actions, these 9 defendants knew their statements about Daou' accounting policy and revenue recognition were false 10 and misleading when made . 11 (d) Defendants knew that Daou had prematurely recognized 100% of the revenue
12 on projects that were not near completion. Between 2Q97 and 3Q97, Daou's accounts receivable, 13 which defendants publicly reported and were aware of, increased $701,000 . According to CW17, 14 a former financial analyst at Daou, defendants knew that the accounts receivable balance at Daou
15 represented labor costs incurred on a project after 100% of the revenue had been recognized under 16 POC accounting. CWl3 confirmed that defendants' premature recognition of 100% of the revenue 17 on contracts resulted in continuing labor costs being allocated to accounts receivable . 18 (e) As described above, Daou's reported 3 Q97 revenue was artificially inflated by
19 the recognition of 20% ofthe revenue of the Company's unsigned contract for a project with Candler 20 Health Systems . According to CW5, who had personal knowledge of the proposed Candler Health 21 Systems project, defendant G. Daou knew of and directed the end-of-the-quarter purchase of 22 equipment and revenue recognition and knew no contract had been signed with Candler .
23 (f) According to CW14, during 3Q97 McGee prepared an earnings model that
24 he sent by facsimile to analysts who covered or reported on Daou . The monthly earnings model
25 included projected revenue and EPS on a quarterly basis for FY98 and FY97 .
26 (g) All of the defendants knew how Daou's results were progressing in 3Q97 and 27 knew that the reported revenue could only be achieved by manipulating the Company's financial
28 results. CWI,CW7, CW9, CW12, CW17 and CW21 all confirm that both actual labor cost s
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I incurred/completed and the estimates used to falsify Daou's revenue recognition were recorded under
2 the direction ofMcNeill and distributed to G . Daou, D . Daou, McGee and, periodically, to directors,
3 including Moragne . Each employee on a Daou project was provided with a workbook containing the
4 template for an Excel spreadsheet. The spreadsheet (the job costing sheet) contained categories for
5 hours worked, along with travel and non-billable time. For each time period (initially Sunday to
6 Sunday, later changed to bi-weekly), the spreadsheet was provided to the project manager . The
7 project manager would compile the billable time, make an estimate, based on the time and costs
8 incurred to date, of the percent of the project that was complete and e-mail the information to Daou's
9 project cost accounting staff in San Diego, who operated under COO McNeill . CWl, a project cost
10 analyst, stated that the time and percentage of completion data was entered into the Company's
11 ManFact accounting system. One or two days before the end ofthe month, Vice Presidents Ringwall
12 and Mirabile would print out the ManFact reports containing actual labor and percent completion
13 submitted by project managers, for the current month and quarter . According to CWI, CW3, CW4,
14 CW6, CW7, the ManFact data was compiled into a Monthly Project Report which was sent to
15 G. Daou, D. Daou, McGee, and McNeill at the close of each month and quarter. The Monthly
16 Project Report contained columns for customer name, project number, contract amounts (total
17 revenue dollars), amount of revenue recognized in the six preceding months (identified by month),
18 revenue to be recognized in the current month, and a 12-month forecast of revenue available to be
19 recognized (identified by month). Based on the comprehensive Monthly Project Report, G . Daou,
20 D. Daou, McNeill and McGee would adjust upward the percent completion for projects . According 21 to CWI, who assisted in preparing the Monthly Project Report, after senior management's (G. Daou,
22 D. Daou, McNeill, McGee) initial review of percentage of completion estimates, he would be directed 23 by Ringwall or Mirabile to make manual adjustments in the ManFact system to increase the
24 percentage of completion estimates submitted by project managers . 25 (h) CW1 further confirmed that Vice President Neil Cassidy and Project Analyst 26 Wayne Walker would make j okes about the inflation of revenue recognition figures after defendants'
27 review of the Monthly Project Report . Likewise, CW3, CW9 and CW27 confirmed that G . Daou,
28 D. Daou and McNeill monitored the actual and reported progress on POC contracts and it wa s
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1 generally believed within the Company that they were improperly recognizing revenue without regard 2 to the actual status of ongoing projects .
3 (i) CW9 confirmed G. Daou and D . Daou were active, day-to-day managers of 4 the Company and routinely met with McNeill and McGee . G. Daou maintained his own project 5 accounts, including Western Tennessee Healthcare, Mercy Health Services and the Stanford Medical 6 Center. D. Daou oversaw mergers and acquisitions, using 6.6 million shares of Daou's artificially 7 inflated stock to acquire 11 companies during the Class Period. CW4 further confirms that G. Daou, 8 D. Daou and McNeill ran the day-to-day Field Services and Sales operations and McGee ran the 9 Accounting Department. 10 (j) During the conference call and subsequent conversations with analysts and
11 money and portfolio managers, defendants G . Daou, D. Daou, McGee and McNeill presented 12 themselves as the persons at Daou most knowledgeable about the Company's reported revenue, 13 earnings expectations, financial results and business. CW14, a former analyst who covered Daou, 14 confirmed that these defendants, and in particular McGee, presented themselves as knowledgeable 15 about all aspects of the Company's finances, including earnings and revenue recognized under POC 16 accounting. 17 (k) D. Daou and McGee signed the report on Form 10-Q for 3Q97 attesting to 18 the information therein and their knowledge of and basis for representing that Daou recognized
19 revenue in line with its stated policy and had 3Q97 revenue of $11 .3 million.
20 (1) Within one month of their positive statements about Daou's 3Q97 financial
21 results, defendants and other insiders took advantage ofDaou's higher stock price . On November 17,
22 1997, defendant Moragne disposed of 11,408 shares of his Daou stock at $31 .69 per share for
23 proceeds of $361,519 . On November 19, 1997, Joseph Daou the father of G . Daou and D. Daou,
24 sold 300,000 shares of his stockholdings at $28 .15 per share for proceeds of $8,445,000. 25 60 . Defendants' false and misleading statements about Daou's 40 and FY97 accounting 26 and financial results : 27 (a) On January 21, 1998, through the Business Wire, Daou published record
28 fourth quarter and year-end financial results. The Company postedfourth quarter and year-en d
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1 revenue of $14.5 million and $41.7 million, respectively, increases over the previous year of 60% 2 and 47%, respectively. Net income was $664,000 for the fourth quarter with a net income for the
3 year of $87,000. 4 DAOU attributes the increase in revenue primarily to continued market demand for the company's core services, the success of the firm's acquisition 5 strategy, continued momentum from recent investments in national sales and marketing programs, and the introduction of new services . 6 7 "Obviously, 1997 has been an outstanding year for our company," said 8 Georges Daou, chief executive officer of DAOU Systems . "We believe we have established a successful business model and a strong foundation that will help 9 carry our momentum into 1998 and beyond ." 10 (b) Subsequent to the release of its 4Q and FY97 results, Daou held a conference
11 call for analysts, money and portfolio managers, institutional investors and large Daou shareholders 12 to discuss Daou's 4Q and FY97 results, its business and its prospects . During the call - and in follow-
1 3 up conversations with analysts - G. Daou, D. Daou, McGee and McNeill stated:
14 Despite a small earnings shortfall, Daou's revenuegrowth continued and orders for
15 1998 were strong . 16 Daou's acquisitions, both those already completed and those in the pipeline for 1998,
17 were all high margin and would contribute to Daou's revenue and earnings growth .
18 Daou was seeing substantial increases in prices for its design services, which would
19 contribute to revenues, margins and earnings growth in 1998 and 1999 .
20 Daou was on track to report 1998 and 1999 EPS of $0.62 and $0.90-$0.92,
21 respectively. 22 (c) On January 22, 1998, securities analysts issued reports on Daou, which were
23 based on and repeated information provided by G. Daou, D . Daou, McGee and McNeill in the
24 conference call and in follow-up conversations. These reports projected earnings for Daou and rated
25 Daou as follows :
26 Firm Date 1998 EPS 1999 EPS Ram Analyst Adams, Harkness 27 & all, Inc. 1/22/98 $0 .62 $0.92 Buy C . Trafton Legg Mason Wood 28 Walker, Inc. 1/22/98 $0.62 $0.92 Buy J . Ackerman BT Alex. Brown 1/22/98 $0.62 $0.90 Strong Buy A. Gallo
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l Cowen & Co. 1/22/98 $0.55 $0.90 Strong Buy S . Tyagi Hambrecht & Quist 1/22/98 $0.62 N/A Strong Buy D. Godsey 2 BancArnerica Robertson Stephens 1/22/98 $0 .62 $0 .92 Buy M. Samols 3 (d) On or about March 10, 1998, Daou filed its Form 10-K for the fiscal year end 4 December 31, 1997, signed by defendants G . Daou, D. Daou, McGee, and Moragne. This report 5 contained the same year end false financial information as was contained in the January 21, 1998 press 6 release and was false and misleading for the same reasons detailed herein, 7 (e) On March 20, 1998, H&Q analyst D. Godsey visited Daou's San Diego 8 headquarters and met with Daou management including G. Daou, D . Daou and McGee. During the 9 visit, Daou management told Godsey that : 10 • Daou was having a strong quarter, and the Company had enormous long-term 11 opportunities. 12 • The outlookfor the Company had never been brighter. 13 • Estimates of $0. 50 and $0.80 for 1998 and 1999, respectively, were the downside 14 possibilities if the Company should have problems closing deals - thus Daou was clearly 15 on track to report strong revenue and earnings growth. 16 (fl On March 23, 1998, H&Q issued a report on Daou written by D . Godsey 17 which was based on and repeated Daou management' s statements to Godsey. The report forecast 18 1998 EPS of $0.62 and rated Daou a "strong buy ." 19 61 . Reasons why defendants' statements were false and misleading: Daou's reported 20 4Q and FY97 financial results and earnings forecasts, claims of dramatic year-to-year revenue growth 21 and statements attributing the Company's "outstanding year," "strong quarter" and bright outlook to 22 increasing revenue from market demand were false and misleading when made . The following facts, 23 corroborated by the accounts of at least 18 confidential witnesses, including accounting, engineering 24 and executive personnel who were based in Daou's San Diego headquarters and at specific Company 25 projects, confirm that, in truth, Daou's financial results and earnings forecasts were false and 26 misleading and were the result of defendants' improper revenue recognition in violation of Daou' s 27 I stated accounting policy and GAAP. 28
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1 (a) Defendants did not recognize revenue in accordance with POC accountin g
2 requirements or Daou's stated accounting policy. POC accounting and GAAP require that revenue
3 not be recognized before it is earned and that all revenue recognized be based on the accurate
4 measure of the labor costs to date compared to the total estimated labor costs for the project .
5 According to CW5, a former engineer and assistant to one ofDaou's Field Services executives, during
6 4Q97 revenue was recognized on Daou's contracts without regard to actual labor costs incurred or
7 projected. CW5, who dealt with accounting for ongoing contracts under defendant McNeill,
8 confirmed that defendants would automatically record 20% of the revenue from a contract upon
9 contract signing, prior to any labor costs being incurred. Forty percent of the revenue from contracts
10 was recognized immediately after any equipment was ordered, and 50%-6O% of the revenue was
11 recognized as soon as the equipment was "burned-in" (configured and tested) . CW5 confirmed that
12 this revenue was recognized without regard to labor costs incurred.
13 (b) CW28, a former. senior network engineer and project manager, who worked
14 on Daou's Mercy Health Services project, confirmed that a fixed amount of revenue was recognized
15 on contracts immediately upon signing, and that the revenue reported by defendants did not reflect
16 labor costs incurred compared to total estimated labor costs . Former Sales executive CW9 further
17 confirmed the accuracy of CW5 and CW28's reports, and stated that during this period defendants
18 would recognize a fixed percentage of revenue upon a contract's signing and upon ordering
19 equipment, even when no labor costs were incurred.
20 (c) 4Q97 and FY97 revenue was artificially inflated to present the image of strong
21 growth and boost Daou's stock price. CWS, a Field Services Engineer during 4Q97, and CW3, a
22 senior Design Engineer during 4Q97, both confirmed that it was known throughout Daou at this time
23 that G. Daou, D. Daou and McNeill were engaged in improper revenue recognition and that revenue
24 on POC contracts was being recognized prematurely (before labor costs were incurred) . According
25 to CW3, CW'V 5,CW 9 andCW28, this premature and improper revenue recognition - violating GAAP
26 and Daou's stated accounting policy - was not limited to one or two contracts, but was true for all
27 or virtually all Daou projects .
28
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1 (d) Had Daou reported revenue in line with the amount it was entitled to bill
2 customers pursuant to its contracts , actually reflecting contract work done to date, revenue for 4Q97
3 would have been only $12 .8 million, 12% less than publicly repo rted ($ 14.5 million) and total revenue
4 for FY97 would have been only $33 . 1 million, 21% less than publicly reported ($41 .7). CW13,
5 CW17 and CW27 that the dramatic growth in Daou's work in progress account, increasing $1 .7
6 million from 3Q97 to 4Q97 and $8 .6 million during FY97, was the result of defendants ' premature
7 recognition of revenue . The work in progress account was comprised almost entirely of contract
8 amounts Daou had recognized as revenue but for which it was not entitled to bill because little or no
9 labor had yet taken place and the percentage of the project actually complete was lower than the
10 percentage completion numbers defendants used to calculate repo rted revenue.
11 (e) The reported increase in revenue during 4Q97 was primarily attributable t o
12 defendants' improper recognition of revenue, not the purported "outstanding year" or market demand .
13 At least 12% of Daou's publicly reported revenue for 4Q97 and 21% of reported revenue for FY97
14 was the result of prematurely recognizing revenue without any basis in actual labor costs incurred or
15 actual total estimated labor costs .
16 (f) Business momentum was not exceptional, and the Centura Health projec t
17 continued to lose money. According to CWIO, a former account manager during 4Q97 , Daou was
18 losing money on the Centura Health account as a result of defendants' recognition of revenue before
19 labor costs were actually incurred . As detailed under 2Q97, CW5 and CW8 both described how
20 defendants recognized 30%-40% of the revenue of the Centura Health contract in 2Q97 based on no
21 more than false records of hours worked and plugging in and turning on computers destined for th e
22 project.
23 (g) Daou's 4Q97 revenues and future outlook were impacted by Candler Health
24 System's decision not to contract with Daou . As described with regard to defendants' false and
25 misleading statements regarding 3Q97, at the end of 3Q97 defendants had ordered equipment for a
26 then under-negotiation contract with Candler Health Systems . Daou immediately recognized revenue
27 on the project without regard to the Company's POC accounting policy and despite the fact that n o
28
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1 II contract was signed . The equipment ordered by Daou for the Candler Health Systems project sat i n 2 Daou's warehouse throughout 4Q97 and was never used on any Daou project .
3 (h) According to CW5 and CW20, by 4Q97 Daou had recognized 100% of the
4 revenue on its Mercy Health Services project, but the project was not near completion . Revenue had
5 been recognized in advance of actual labor costs incurred and without regard to actual labor costs
6 necessary to complete the project . As a result, according to CW20, who was a Field Services
7 engineer on the Mercy Health Services project, requisite onsite engineers were withdrawn from the
8 project and , according to CW5 labor costs incurred were "overbudget ," going to Daou's accounts
9 receivable balance.
10 (i) CW16, a financial analyst under McNeill , confirmed that the projects he
11 reviewed for which Daou had recognized 95% of the revenue were nowhere near 95% complete .
12 This was well known among Daou's financial analysts and consultants as con firmed by CW12 and
13 CW17.
14 (j) Defendants' statements about Daou's 4Q and FY97 revenue were also false
15 because, in addition to the immediate recognition of revenue after a contract was signed or equipment
16 was ordered (and at a time when little or no labor costs had been incurred), defendants manipulated
17 the actual labor costs incurred and estimated total labor costs. According to CW 12 and CW28, both
18 Field Services Engineers in FY97, the estimates of total labor costs provided by senior managers at
19 project sites were routinely ignored for revenue recognition purposes . The estimates of total labor
20 hours used to calculate revenue by defendants G . Daou, D. Daou, McNeill and McGee were,
21 according to CW 12, grossly understated and did not reflect the opinions of the on-site managers .
22 CW28 further confirms that, during this period, he was told by Field Services Vice President Mirabile,
23 who worked at the direction of McNeill, what percent complete his projects were (for revenue
24 recognition purposes) and that these figures did not reflect the actual labor completed or labor
25 required to complete the projects . According to CW28, based on his firsthand knowledge from Daou
26 projects, the actual percentage of completion numbers were adjusted upward by Daou's senior
27 executives to boost reported revenue.
28
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1 (k) Daou was not on track to achieve FY98 EPS of $0.62 or FY99 EPS of $0 .90-
2 $0.92 because defendants were prematurely recognizing revenue in violation of GAAP and the
3 Company's stated accounting policy on contracts that would take years to complete . As a result,
4 according to CW3 and CW24, project managers were told that projects were "closed" for billing
5 purposes, when the projects were actually far from completion . CW17, a financial analyst in Daou's
6 San Diego headquarters, confirmed that, at the direction of McNeill, labor costs incurred after 100%
7 of the revenue on the project was recognized were dumped into accounts receivable . After
8 defendants finally reported Daou's disastrous 3Q98 results and revealed the financial impact of their
9 accounting manipulations, Daou reported a FY98 loss of $0 .33 per share. For FY99 Daou reported
10 a loss of $0.52 per share, nowhere close to the projected earnings of $0.90-$0.92. 11 (1) CW2, a training manager based in Daou's headquarters during 4Q97, reported 12 that he was specifically told by both a senior-level network engineer and a Field Services project 13 manager that defendants' revenue recognition on their projects was improper and was not based on
14 Daou's stated POC accounting policy . As a result, according to CW2, both the network engineer and 15 project manager left Daou after making their complaints about improper revenue recognition. 16 (m) Daou's work in progress account was primarily unbilled receivables, not
17 hardware purchases for which no revenue had been recognized. CW4 and CW5 both confirm that 18 Daou recognized a fixed percentage of revenue immediately upon ordering and receiving equipment
19 for a project . CW13 and CW17, as detailed above, further confirmed that the work in progress 20 account was comprised almost entirely of contract amounts Daou had recognized as revenue but for 21 which it was not entitled to bill because little or no labor had yet taken place and the percentage of 22 the project actually complete was lower than the percentage completion numbers defendants used to
23 calculate reported revenue.
24 62. Defendants' knowledge of falsity: Based on the reports of numerous witnesses, all 25 of whom were former members of Daou's Executive, Accounting or Field Services staff, defendants
26 not only knew that the Company's reported financial results and earnings forecast were based on
27 fraudulent accounting, but personally directed the violations of GAAP in order to artificially inflate
28 revenues.
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1 (a) Defendants G. Daou, D. Daou, McNeill and McGee personally directed Daou's 2 recognition of revenue, financial reporting and public statements . Not only were these four 3 defendants the top executives at Daou, but, according to CW23, a former executive assistant to one 4 of the defendants, the Company was run "top to bottom" by G . Daou and D. Daou, with the 5 assistance of McNeill and McGee. G. Daou and D . Daou, confirmed CW23, were particularly 6 concerned with the Company's revenue recognition and exceeding the Company's projected revenue 7 and earnings, and made the final decisions on POC accounting revenue to be recognized . 8 (b) On January 29, 1998, only one week after defendants released Daou's
9 "outstanding" 4Q and FY97 results and analysts rated the Company a "strong buy" based on meetings
10 with G. Daou, D. Daou, McGee and McNeill, G . Daou and D . Daou further liquidated their holdings . 11 Specifically, G . Daou and D. Daou each sold 75,000 shares of their Daou stock for proceeds of 12 $2,429,000 . 13 (c) CW13 confirmed that McNeill provided G . Daou and D . Daou with all raw 14 POC and revenue recognition figures and, together with McGee, they personally determined what
15 revenue Daou would publicly report. According to CW5, who reported to McNeill, McNeill,
16 G. Daou and D. Daou paid particularly close attention to the POC and revenue recognition numbers, 17 and were, with McGee, the only people at Daou who could determine how much revenue to publicly
18 report. CW15 further confirmed that all decisions regarding recognition of revenue on Daou's 19 contracts were made by McNeill, G . Daou and D . Daou.
20 (d) CW9, a regional Sales Vice President at Daou, confirmed that defendants G .
21 Daou, D. Daou and McNeill not only made the decision on how much revenue to recognize without
22 regard to any actual percentage of completion, but directed the practice of automatically recognizing
23 revenue upon contract signing and ordering of equipment . Accordingly, from their own actions, these
24 defendants knew their statements about Daou' accounting policy and revenue recognition were false
25 and misleading when made . 26 (e) Defendants knew that Daou had prematurely recognized 100% of the revenue
27 on projects that were not near completion . Between 3Q97 and 4Q97, Daou's accounts receivable, 28 which defendants publicly reported and were aware of, increased $4 .767 million. According to
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I CW17, a former financial analyst at Daou, defendants knew that the accounts receivable balance at 2 Daou represented labor costs incurred on a project after 100% of the revenue had been recognized 3 under POC accounting. CW 13 confirmed that defendants' premature recognition of 100% of the 4 revenue on contracts resulted in continuing labor costs being allocated to accounts receivable .
5 (f) According to CW14, during 4Q97 McGee prepared an earnings model that 6 he sent by facsimile to analysts who covered or reported on Daou . The monthly earnings model 7 included projected revenue and EPS on a quarterly basis for FY98 and FY97 .
8 (g) All of the defendants knew how Daou's results were progressing in 4Q97 and
9 knew that the reported revenue could only be achieved by manipulating the Company's financial
10 results. CWI,CW5, CW7, CW12, CW17, and CW21 all confirm that both actual labor costs
11 incurred/completed and the estimates used to falsify Daou's revenue recognitionwere recorded under
12 the direction of McNeill and distributed to G . Daou, D. Daou, McGee and periodically to directors,
13 including Moragne. Each employee on a Daou project was provided with a workbook containing the
14 template for an Excel spreadsheet . The spreadsheet (the job costing sheet) contained categories for
15 hours worked, along with travel and non-billable time. For each time period (initially Sunday to
16 Sunday, later changed to bi-weekly), the spreadsheet was provided to the project manager . The
17 project manager would compile the billable time, make an estimate, based on the time and costs
18 incurred to date, of the percent of the project that was complete and e-mail the information to Daou's
19 project cost accounting staff in San Diego, who operated under COO McNeill . CWI, a project cost
20 analyst, stated that the time and percentage of completion data was entered into the Company's
21 ManFact accounting system. One or two days before the end of the month, Vice Presidents Ringwall
22 and Mirabile would print out the ManFact reports containing actual labor and percent completion
23 submitted by project managers for the current month and quarter . According to CWI, CW3, CW4,
24 CW7 and CW 16, the ManFact data was compiled into a Monthly Project Report which was sent to
25 G. Daou, D . Daou, McGee, and McNeill at the close of each month and quarter. The Monthly
26 Project Report contained columns for customer name, project number, contract amounts (total
27 revenue dollars), amount of revenue recognized in the six preceding months (identified by month),
28 revenue to be recognized in the current month, and a 12-month forecast of revenue available to b e
-63- 98cv1537 -L(CGA) LJ ►. J
1 recognized (identified by month) . Based on the comprehensive Monthly Project Report, G . Daou, 2 D. Daou, McNeill and McGee would adjust upward the percent completion for projects . According
3 to CW 1, who assisted in preparing the Monthly Project Report, after senior management's (G . Daou, 4 D. Daou, McNeill, McGee) initial review ofpercentage of completion estimates, he would be directed
5 by Ringwall or Mirabile to make manual adjustments in the ManFact system to increase the 6 percentage of completion estimates submitted by project managers .
7 (h) CWI further confirmed that Vice President Neil Cassidy and Project Analyst I 8 Wayne Walker would make jokes about the inflation of revenue recognition figures after defendants' 9 review of the Monthly Project Report . Likewise, CW3, CW9 and CW27 confirmed that G. Daou, 10 D. Daou and McNeill monitored the actual and reported progress on POC contracts and it was 11 generally believed within the Company that they were improperly recognizing revenue without regar d 12 to the actual status of ongoing projects . 13 (i) CW9 confirmed G. Daou and D . Daou were active, day-to-day managers of 14 the Company and routinely met with McNeill and McGee. G. Daou maintained his own project 15 accounts, including Western Tennessee Healthcare, Mercy Health Services and the Stanford Medica l
16 Center. D. Daou oversaw mergers and acquisitions, using 6 .6 million shares of Daou's artificially 17 inflated stock to acquire 11 companies during the Class Period . CW4 further confirms that G. Daou, 18' D. Daou and McNeill ran the day-to-day Field Services and Sales operations and McGee ran th e
19 Accounting Department. 20 (j) During the conference call and subsequent conversations with analysts and
21 money and portfolio managers, defendants G . Daou, D. Daou, McGee and McNeill presented 22 themselves as the persons at Daou most knowledgeable about the Company's reported revenue ,
23 earnings expectations, financial results and business . CW14 . a former analyst who covered Daou,
24 confirmed that these defendants, and in particular McGee, presented themselves as knowledgeable
25 about all aspects of the Company's finances, including earnings and revenue recognized under POC 26 I accounting. . 27
28
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1 (k) G. Daou, D. Daou, McGee and Moragne signed the report on Form 10-K for 2 FY97 attesting to the information therein and their knowledge of and basis for representing that Daou 3 recognized revenue in he with its stated policy and had 4Q97 revenue of $14 .5 million.
4 63. In March 1998, with Daou stock trading at artificially inflated prices as a result of 5 defendants' false and misleading statements, defendants, led by D . Daou, acquired Sentient Systems, 6 Inc. and Synexus, Inc . in exchange for 1 .6 million shares of stock valued, at the time, at $33.0 million. 7 64. Defendants'false and misleading statements about Daou 's 1 Q98 accounting and 8 financial reports: 9 (a) On April 23, 1998, through the Business Wire, the Company announced
10 record results for the first quarter of 1998 reporting revenues of $18,063,000, operating income 11 of $454,000, accounts receivable of $16,546,000 and contract work in progress of $20,126,000 :
12 The company posted first-quarter revenue of $18.1 million, a 79 percent increase over the $10.1 million reported for the first quarter of 1997 . Net income for 13 the quarter was $1 .4 million (before one-time merger costs of $1 .7 million), compared to net income of $160,000 for the same period last year . 14 Dilutedfirst-quarter earnings per share (before one-time merger costs of 15 $0.13 per share) are $0.10 per share, which compares to a net income of $0 .01 per share for the same period in 1997 . 16 DAOU attributes the increase in revenue and earnings to a broader 17 penetration of the healthcare technology market, new service offerings, recent mergers that provide customers with a more comprehensive line of services, and an 18 increased utilization of the company's growing sales force .
19 20 "We have begun the year in solid fashion," said Georges Daou, chief executive officer of DAOU Systems. "Our customer base grew, our marketshare 21 is expanded, and demandfor our services appears high . Furthermore, we have continued our mergers and acquisitions strategy, which will provide us with an even 22 larger foothold in the market , as well as an end-to-end set of technology solutions for our customers ." 23 (b) On April 23, 1998, subsequent to the release of its 1 Q98 results, Daou hosted 24 a conference call for analysts, money and portfolio managers, institutional investors and large Daou 25 shareholders to discuss Daou's 1Q results, business and prospects . During the call, and in follow-up 26 conversations with analysts, G. Daou, D . Daou, McGee and McNeill stated: 27 • Daou's spectacular IQ results were due to strong performance in its core 28 networking services business , as well as new service offerings . -65- 98cvl537-L(CGA) E
1 Daou was successfully adding new customers and its momentum was increasing . 2 Although contract work-in-progress increased to $20. 1 million, this was no cause 3 for concern as unbilled receivables represented only $900, 000 of this amount, and the rest
4 was hardware purchased and labor hours for which no revenue had been recognized. 5 Daou was on track to report EPS of $0.62 and $0.90-$0.95 in 1998 and 1999, 6 respectively. 7 (c) On April 24-27, 1998, securities analysts issued reports on Daou, which were
8 based on and repeated information provided by G. Daou, D. Daou, McGee and McNeill in the 9 conference call and in fo llow-up conversations. These reports projected earnings for Daou and rated
10 Daou as follows:
11 Firm Date 1998 EPS 1999 EPS Rating Analyst
12 Hambrecht & Quist 4/27/98 $0 .62 $0 .90 Strong Buy D . Godsey Cowen & Co. 4/24/98 $0 .55 $0.90 Buy S. Tyagi 13 Legg Mason 4/24/98 $0 .62 $0 .92 Buy J. Ackerman Loewenbaum & Co. 4/24/98 $0.63 $0 .95 Strong Buy M . McEnroe 14 Adams, Harkness & Hill 4/24/98 $0.62 $0 .92 Buy C . Trafton BT. Alex. Brown 4/24/98 $0.62 $0 .90 Strong Buy A. Gallo 15 BancAcnerica Robertson Stephens 4/24/98 $0.62 $0.92 Buy M . Samols 16 (d) On or about May 15, 1998, Daou filed its report on Form 10-Q for the quarter 17 ended March 31, 1998, signed by defendants D . Daou and McGee . Defendants represented that 18 "[t]hese financial statements reflect all adjustments , consisting of only normal recurring adjustments 19 which in the opinion of management, are necessary to fairly present the financial position [of Daou] 20 at March 31, 1998 and the result of operations for the three -month periods ended March 31, 1998 21 and 1997." This report contained the same false information as was contained in the Ap ril 23, 1998 22 press release and was false and misleading for the same re asons detailed herein. 23 65. Reasons why defendants' IQ98 statements were false and misleading: Daou's 24 reported 1 Q98 financial results and earnings forecasts, statements regarding dramatic year -to-year 25 revenue growth, increasing momentum and "spectacular " results and claims that increasing work in 26 progress were no cause for concern were false and misleading when made . The following facts, 27 corroborated by the accounts of at least 16 con fidential witnesses, including accounting, engineering 28 and executive personnel based in Daou's headquarters and at specific Company projects, confirm that,
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I in truth, Daou's financial results and earnings forecasts were false and misleading and the result of 2 defendants' improper revenue recognition in violation of Daou's stated accounting policy and GAAP . 3 (a) Defendants did not recognize revenue in accordance with POC accounting 4 requirements or Daou's stated accounting policy . POC accounting and GAAP requires that revenue
5 not .be recognized before it is earned and that all revenue recognized be based on the accurate 6 measure of the labor costs to date compared to the total estimated labor costs for the project . 7 According to CW5, a former engineer and assistant to one of Daou's Field Services executives, 8 revenue was recognized on Daou's contracts without regard to actual labor costs incurred or
9 projected. CW5, who dealt with accounting for ongoing contracts under defendant McNeill, 10 confirmed that defendants would automatically record 20% of the revenue from a contract upon
1 i contract signing, prior to any labor costs being incurred . Forty percent of the revenue from contracts 12 was recognized immediately after any equipment was ordered, and 50%-60% of the revenue was 13 recognized as soon as the equipment was "burned-in" (configured and tested) . CW5 confirmed that 14 this revenue was recognized without regard to labor costs incurred . 15 (b) CW28, a former senior network engineer and project manager, confirmed that
16 a fixed amount of revenue was recognized on contracts immediately upon signing, and that the 17 revenue reported by defendants did not reflect labor costs incurred compared to total estimated labor
18 costs. Former Sales executive CW9 further confirmed the accuracy of CW5 and CW28 s'reports, and 19 identified that during this period defendants would recognize a fixed percentage of revenue upon a 20 contract signing and upon ordering equipment, even when no labor costs were incurred.
21 (c) 1 Q98 revenue was artificially inflated to present the image of strong growth
22 and boost Daou's stock price . CW8, a Field Services Engineer, and CW3, a senior Design Engineer,
23 both confirmed that it was known throughout Daou at this time that G . Daou, D . Daou and McNeill
24 were engaged in improper revenue recognition and that revenue on POC contracts was being
25 recognized prematurely (before labor costs were incurred) . According to CW3, CWS, CW9 and
26 CW28, this premature and improper revenue recognition - violating GAAP and Daou's stated
27 accounting policy - was not limited to one or two contracts, but was true for all or virtually all Daou
28 projects .
67 - 98cv1537-L(CGA) 0 U
I (d) Had Daou reported revenue in line with the amount it was entitled to bill 2 customers pursuant to its contracts, actually reflecting contract work done to date, revenue for 1 Q98 3 would have been only $10 .3 million, 43% less than publicly reported ($18.1 million). CW 13, CW 17 4 and CW27 confirmed that the dramatic growth in Daou's work in progress account, increasing $7 .8
5 million from 4Q97 to 1Q98, was the result of defendants' premature recognition of revenue . The 6 work in progress account was comprised almost entirely of contract amounts Daou had recognized 7 as revenue but for which it was not entitled to bill because little or no labor had yet taken place and 8 the percentage of the project actually complete was lower than the percentage completion numbers
9 defendants used to calculate reported revenue . 10 (e) The reported increase in revenue during 1 Q98 was primarily attributable to
11 defendants' improper recognition ofrevenue, not the purported "outstanding year" or market demand . 12 At least 43% ofDaou's publicly reported revenue for 1 Q98 was the result of prematurely recognizing
1 3 revenue without any basis in actual labor costs incurred or actual total estimated labor costs . But for 14 the improperly recognized revenue, Daou would have had to report flat year-to-year growth . 15 (f) According to CW5 and CW20, by 4Q97 and into 1Q98 Daou had recognized 16 100% of the revenue on its Mercy Health Services project, but the project was not near completion .
17 Revenue had been recognized in advance of actual labor costs incurred and without regard to actual 18 labor costs necessary to complete the project, As a result, according to CW20, who was a Field 19 Services engineer on the Mercy Health Services project, requisite onsite engineers were withdrawn 20 from the project and, according to CW5, labor costs incurred were "overbudget," going to Daou's
21 accounts receivable balance .
22 (g) Similarly, CW22 confirmed that personnel were pulled from Daou's Huntington
23 Memorial Hospital (California) project before the project was completed, apparently because Daou
24 had already recognized 100% of the revenue from the project contract . 25 (h) According to CW24, in IQ98 Daou began to recognize revenue on a
26 $2,000,000 call center project with the University of Chicago (Illinois), when no contract had been
27 signed. According to CW24, McNeill closely monitored the University of Chicago project and knew
28 that the strategic plan for implementing the project was not completed until April 1998 (2Q98) and ,
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1 as of June 30, 1998 (2Q98), Daou and the University of Chicago still had not agreed on the terms of
2 the project . Later in the project, when CW24 submitted a job costing sheet detailing labor costs 3 incurred, she was told by Field Services department executives, operating under McNeill, that the 4 project had been "closed" for billing purposes, even though the project was not close to completion .
5 (i) CWI, who received and entered POC data in the Company's ManFact 6 accounting system, stated that by 1 Q98 Daou had recognized 100% ofthe revenue on the Company's 7 St. Mary's Health Network (Nevada) project, but that Field Services continued to submit job costing
8 sheets, because the project was not 100% complete . According to CWI, approximately $4 million 9 in labor costs were incurred after Daou had recognized 100% of the revenue from the St . Mary's 10 Health Network contract.
I 1 6) Defendants' statements about Daou's 1Q98 revenue were also false because,
12 in addition to the immediate recognition of revenue after a contract was signed or equipment was
13 ordered (and at a time when little or no labor costs had been incurred), defendants manipulated the
14 actual labor costs incurred and estimated total labor costs . According to CW12 and CW 28, both
15 Field Services engineers, the estimates of total labor costs provided by senior managers at project
16 sites were routinely ignored for revenue recognition purposes . The estimates of total labor hours
17 used to calculate revenue by defendants G. Daou, D. Daou, McNeill and McGee were, according to
18 CW12; grossly understated and did not reflect the opinions of the on-site managers . CW28 further
19 confirms that, during this period, he was told by Field Services Vice President Mirabile, who worked
20 at the direction of McNeill, what percent complete his projects were (for revenue recognition
21 purposes) and that these figures did not reflect the actual labor completed or labor required to
22 complete the projects . According to CW28, based on his firsthand knowledge from Daou projects,
23 the actual percentage of completion numbers were adjusted upward by Daou's senior executives to
24 boost reported revenue. 25 (k) Daou was not on track to achieve FY98 EPS of $0 .62 or FY99 EPS of $0.90- 26 $0.99,. because defendants were prematurely recognizing revenue, in violation of GAAP and the 27 Company's stated accounting policy, on contracts that would take years to complete . As a result, 28 according to CW3 and CW24, project managers were told that projects were "closed" for billin g
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1 purposes, when the projects were actually far from completion . CW 17, a financial analyst in Daou's 2 San Diego headquarters, confirmed that, at the direction of McNeill, labor costs incurred after 100%
3 of the revenue on the project was recognized, were dumped into accounts receivable . After 4 defendants finally reported Daou's disastrous 3Q98 results and revealed the financial impact of their
5 accounting manipulations, Daou reported a FY98 loss of $0 .33 per share. For FY99 Daou reported
6 a loss of $0 .52 per share, nowhere close to the projected earnings of $0.90-$0.92. 7 (1) CW2, a training manager based in Daou's headquarters reported that he was 8 specifically told by both a senior-level network engineer and a Field Services project manager that 9 defendants' revenue recognition on their projects was improper and was not based on Daou's stated
10 POC accounting policy. As a result, according to CW2, both the network engineer and project 11 manager left Daou after making their complaints about improper revenue recognition . 12 (m) Daou's work in progress account was primarily unbilled receivables, not
13 hardware purchases for which no revenue had been recognized. CW4 and CW5 both confirm that 14 Daou recognized a fixed percentage of revenue immediately upon ordering and receiving equipment
15 for a project . CW13 and CW 17, as detailed above, further confirmed that the work in progress 16 account was comprised almost entirely of contract amounts Daou had recognized as revenue but for 17 which it was not entitled to bill because little or no labor had yet taken place and the percentage of
18 the project actually complete was lower than the percentage completion numbers defendants used to
19 calculate reported revenue .
20 66. Defendants' knowledge of falsity: Based on the reports of numerous witnesses, all 21 of whom were former members of Daou's executive, Accounting or Field Services staff, defendants
22 not only knew that the Company's reported financial results and earnings forecast were based on
23 fraudulent accounting, but personally directed the violations of Daou's stated accounting policy and
24 GAAP in order to artificially inflate revenues .
25 (a) Defendants G . Daou, D. Daou, McNeill and McGee personally directed Daou's
26 recognition of revenue, financial reporting and public statements . Not only were these four
27 defendants the top executives at Daou, but, according to CW23, a former executive assistant to one
28 of the defendants, the Company was run "top to bottom" by G . Daou and D. Daou, with the
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1 I assistance of McNeill and McGee . G. Daou and D. Daou, confirmed CW23, were particularly 2 concerned with the Company's revenue recognition and exceeding the Company's projected revenue
3 and earnings, and made the final decisions on POC accounting revenue to be recognized . 4 (b) CW13 confirmed that McNeill provided G . Daou and D. Daou with all raw
5 POC and revenue recognition figures and, together with McGee, they personally determined what
6 revenue Daou would publicly report. According to CWS, who reported to McNeill, McNeill, 7 G. Daou and D . Daou paid particularly close attention to the POC and revenue recognition numbers,
81, and were, with McGee, the only people at Daou who could determine how much revenue to publicly
9 report. CW15 further confirmed that all decisions regarding recognition of revenue on Daou' s
10 contracts were made by McNeill, G. Daou and D. Daou. 11 (c) CW9, a regional Sales Vice President at Daou, confirmed that defendants
12 G. Daou, D . Daou and McNeill not only made the decision on how much revenue to recogniz e
13 without regard to any actual percentage of completion, but directed the practice of automatically
14 recognizing revenue upon contract signing and ordering of equipment . Accordingly, from their own
15 actions, these defendants knew their statements about Daou' accounting policy and revenue
16 recognition were false and misleading when made.
17 (d) According to CW 13, a former Daou Accounting Department Manager, in
18 1Q98 the Accounting Department, at McGee's direction, did a study of Daou's 100 largest contracts
19 to identify the discrepancies between revenue recognized and actual billing . For nearly every single
20 contract, the amount of revenue recognized greatly exceeded the amount that Daou could bill,
21 indicating revenue recognized out of line with the percentage of the project actually completed .
22 CWI 3 confirmed that the final report was provided to and discussed by G. Daou, D . Daou, McNeill, 23 McGee and Neil Cassidy.
24 (e) CW 18, a finance consultant at Daou, confirmed that during 1 Q98 and 2Q98,
25 and likely before, Neil Cassidy prepared a weekly update and forecast of actual versus projected
26 revenue and results, highlighting the gap between revenue that could properly be recognized and the
27 amount of revenue necessary to meet or exceed projections reported by analysts covering Daou.
28
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I According to CW 18, who worked with Cassidy, Cassidy's weekly report was distributed to Daou'
2 senior management, D. Daou, G. Daou, McNeill and McGee. 3 (f) As identified by CW24 and described above, McNeill closely monitored the 4 University of Chicago project and knew, in 1 Q98, when revenue was recognized, that the strategic
5 plan for implementation was not complete and Daou and the University had not agreed on terms for 6 the project.
7 (g) CW17 was hired by Daou in late 1998 to assist in reconciling the Company's
8 work in progress account with "unearned revenue" recognized in 1Q98 and 2Q98 . According to
9 CW17, McGee and Daou's senior management knew that revenue had been booked without relation
10 to labor costs actually incurred or the percentage of a contract completed. CW 17 confirmed, based
11 on a review of Daou' 1Q98 and 2Q98 contracts, including the St. Mary's Hospital contract, that the
12 POC figures had been "massaged" in order to report inflated revenue.
13 (h) Defendants knew that Daou had prematurely recognized 100% ofthe revenue 14 on projects that were not near completion . Between 4Q97 and 1Q98, Daou's accounts receivable, 15 which defendants publicly reported and were aware of increased $5 .49 million. According to CW 17, 16 a former financial analyst at Daou, defendants knew that the accounts receivable balance at Daou 17 represented labor costs incurred on a project after 100% of the revenue had been recognized under 18 POC accounting. CW 13 confirmed that defendants' premature recognition of 100% of the revenue
19 on contracts results in continuing labor costs being allocated to accounts receivable .
20 (i) All of the defendants knew how Daou's results were progressing in 1 Q98 and
21 knew that the reported revenue could only be achieved by manipulating the Company's financial
22 results. CW 1, CW5, CW7, CW12, CW 17 and CW21 all confirm that both actual labor costs
23 incurred/completed and the estimates used to falsify Daou's revenue recognition were recorded under
24 the direction of McNeill and distributed to G . Daou, D . Daou, McGee and, periodically to directors
25 including Moragne . Each employee on a Daou project was provided with a workbook containing the
26 template for an Excel spreadsheet . The spreadsheet (the job costing sheet) contained categories for
27 hours worked, along with travel and non-billable time . For each time period (initially Sunday to
28 Sunday, later changed to bi-weekly), the spreadsheet was provided to the project manager . The
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1 project manager would compile the billable time, make an estimate, based on the time and costs
2 incurred to date, of the percent ofthe project that was complete and e-mail the information to Daou's 3 project cost accounting staff in San Diego, who operated under COO McNeill . CW1, a project cost 4 analyst, stated that the time and percentage of completion data was entered into the Company's 5 ManFact accounting system. One or two days before the end of the month, Vice Presidents Ringwall 6 and Mirabile would print out the ManFact reports containing actual labor and percent completion 7 submitted by project managers, for the current month and quarter . According to CWI, CW3, CW4, 8 CW7 and CW 16, the ManFact data was compiled into a Monthly Project Report which was sent to
9 G. Daou, D . Daou, McGee, and McNeill at the close of each month and quarter. The Monthly 10 Project Report contained columns for customer name, project number, contract amounts (total 11 revenue dollars), amount of revenue recognized in the six preceding months (identified by month), 12 revenue to be recognized in the current month, and a 12-month forecast of revenue available to be 13 recognized (identified by month). Based on the comprehensive Monthly Project Report, G . Daou, 14 D. Daou, McNeill and McGee, would adjust upward the percent completion for projects . According 15 to CW 1, who assisted in preparing the Monthly Project Report, after senior management's (G . Daou, 16 D. Daou, McNeill, McGee) initial review of percentage ofcompletion estimates, he would be directed 17 by Ringwall or Mirabile to make manual adjustments in the ManFact system to increase the
18 percentage of completion estimates submitted by project managers .
19 (j) CWl further confirmed that Vice President Neil Cassidy and Project Analyst
20 Wayne Walker would make jokes about the inflation of revenue recognition figures after defendants'
21 review of the Monthly Project Report . Likewise, CW3, CW9 and CW27 confirmed that G . Daou,
22 D. Daou and McNeill monitored the actual and reported progress on POC contracts and it was
23 generally believed within the Company that they were improperly recognizing revenue without regard
24 to the actual status of ongoing projects. 25 (k) CW9 confirmed G, Daou and D . Daou were active, day-to-day managers of 26 the Company and routinely met with McNeill and McGee . G. Daou maintained his own project 27 accounts, including Western Tennessee Healthcare, Mercy Health Services and the Stanford Medical 28 Center. D . Daou oversaw mergers and acquisitions, using 6 .6 million shares of Daou's artificiall y
-73- 98cv1537 -L(CGA) I inflated stock to acquire 11 companies during the Class Period. CW4 further confirms that G . Daou, 2 D. Daou and McNeill ran the day-to-day Field Services and Sales operations and McGee ran the 3 Accounting Department .
4 (1) During the conference call and subsequent conversations with analysts and
5 money and portfolio managers, defendants G. Daou, D. Daou, McGee and McNeill presented
6 themselves as the persons at Daou most knowledgeable about the Company's reported revenue,
7 earnings expectations, financial results and business . CW14, a former analyst who covered Daou,
8 confirmed that these defendants, and in particular McGee, presented themselves as knowledgeable
9 about all aspects of the Company's finances, including earnings and revenue recognized under POC
10 accounting.
11 (m) D. Daou and McGee signed the report on Form 10-Q for 1Q98 attesting to 12 the information therein and their knowledge of and basis for representing that Daou recognized 13 revenue in line with its stated policy and had 1 Q98 revenue of $18 .1 million. 14 67. Defendants 'false and misleading statements about Daou's 2Q98 accounting and
15 financial reports : 16 (a) On June 18,1998, H&Q issued a report on Daou written after discussions with
17 defendants G. Daou, D. Daou and McGee, which was based on and repeated information provided 18 by them. The report stated : 19 Following our meeting yesterday at the company, we received incremental news that the June quarter continues to be strong: we expect DAOU to meet or 20 possibly exceed our June quarter estimate of $0.12 on revenue of $19.9 million. 21 We expect both nominal accounts receivable dollars, the WIP account, and DSOs to decline in Q2. As such, we expect cash flow to be moving toward break-even 22 during the quarter. 23 The report reiterated H&Q's strong buy recommendation.
24 (b) On July 29,1998, through the Business Wire, the Company announcedrecord
25 results for the second quarter and first half of 1998, reporting, for Q2 1998, revenues of
26 $28,043,000, operating income of $1,453,000, accounts receivable of $19,978,000 and contracts
27 work in progress of $22,329,000 :
28 For the quarter, DAOU reported revenues of $28 million, up 89 % over the second-quarter 1997 revenues of $14.8 million. Net income for the second quarter
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1 of 1998 was $2.2 million, or $0.12 per share (Rrior to one-time merger costs of $2 .9 million or $0.16 per), compared to net income of $0 .5 million, or $0.03 per share, for 2 the same period last year . 3 4 "We are very pleased with DAOU's performance during the first six months of 1998, and with our prospects as we enter the second half of the year," stated 5 Georges Daou, chief executive officer of DAOU Systems . "We Intend to add new customers and grow our market share as we broaden our service capabilities through 6 internal development, acquisitions and expanded relationships with software vendors . The integration of our traditional infrastructure services and new healthcare IT 7 consulting capabilities is progressing well, and the availability of our expanded service offerings is creating additional cross-selling opportunities for DAOU ." 8 (c) Subsequent to the release of its 2Q98 results, Daou held a conference call for 9 analysts, money and portfolio managers, institutional investors and large Daou shareholders to discuss 10 Daou's results, its business and its prospects . During the call - and in follow-up conversations with 11 analysts -- G. Daou, D. Daou, McGee and McNeill stated: 12 Daou's excellent 2Q results ($11.13 EPS before merger charges) was due to strong 13 demand for its products and services and Daou's leveraging of its operating expenses . 14 • Daou was on track to report EPS of $0.62-$0.64 and $0.90-$0.97 in 1998 and 15 1999, respectively. 16 (d) On July 30,1998, securities analysts issued reports on Daou, which were based 17 on and repeated information provided by G . Daou and D. Daou in the conference call and in follow- 18 up conversations. These reports projected earnings for Daou and rated Daou as follows : 19 Firm Date 199$ EPS 1999 EPS Rating Analyst 20 Loewenbaum & Co. 7/30/98 $0 .64 $0.97 Strong Buy C . Kislin BancAmeric a 21 Robertson Stephens 7/30/98 $0 .66 $0.94 Buy M . Samols Hambrecht & Quist 7/30/98 $0 .67 $0.90 Strong Buy D . Godsey 22 Adams, Harkness & Hill 7/30/98 $0 .65 $0.97 Buy C . Trafton SG. Cowen Securities 7/30/98 $0 .50 $0.80 Buy S. Tyagi 23 68 . Reasons why defendants' 2Q98 statements were false and misleading : Daou's 24 reported 2Q98 financial results and earnings forecasts, and defendants' statements attributing the 25 "excellent Q2 results" to strong demand and new customers, were false and misleading when made. 26 The following facts, corroborated by the accounts of at least 14 confidenti al witnesses, including 27 accounting, engineering and executive personnel based in Daou's San Diego headquarters and at 28 specific Company projects, confirm that, in truth, Daou's financial results and earnings forecasts were
-75- 98cv1537-L(CGA) • .
1 false and misleading and the result of defendants' improper revenue recognition in violation ofDaou's 2 stated accounting policy and GAAP . 3 (a) Defendants did not recognize revenue in accordance with POC accounting
4 requirements or Daou's stated accounting policy . POC accounting and GAAP require that revenue 5 not be recognized before it is earned and that all revenue recognized be based on the accurate
6 measure of the labor costs to date compared to the total estimated labor costs for the project . 7 According to CW5, a former engineer and assistant to one of Daou's Field Services executives, 8 revenue was recognized on Daou's contracts without regard to actual labor costs incurred or 9 projected. CW5, who dealt with accounting for ongoing contracts under defendant McNeill, 10 confirmed that defendants would automatically record 20% of the revenue from a contract upon
11 contract signing, prior to any labor costs being incurred . Forty percent of the revenue from contracts 12 was recognized immediately after any equipment was ordered, and 50%-60% of the revenue was 13 recognized as soon as the equipment was "burned-in" (configured and tested) . CW5 confirmed that 14 this revenue was recognized without regard to labor costs incurred . 15 (b) CW28, a former senior network engineer and project manager, confirmed that 16 a fixed amount of revenue was recognized on contracts immediately upon signing, and that the 17 revenue reported by defendants did not reflect labor costs incurred compared to total estimated labor
18 costs. Former Sales executive CW9 further confirmed the accuracy of CW5 and CW28's reports, and 19 identified that during this period defendants would recognize a fixed percentage of revenue upon a 20 contract signing and upon ordering equipment, even when no labor costs were incurred.
21 (c) 2Q98 revenue was artificially inflated to present the image of strong growth
22 and boost Daou's stock price. CW8, a Field Services Engineer, and CW3, a senior Design Engineer,
23 both confirmed that it was known throughout Daou at this time that G . Daou, D. Daou and McNeill
24 were engaged in improper revenue recognition and that revenue on POC contracts was being
25 recognized prematurely (before labor costs were incurred) . According to CW3, CW5, CW9 and
26 CW12, this premature and improper revenue recognition - violating GAAP and Daou's stated
27 accounting policy - was not limited to one or two contracts, but was true for all or virtually all Daou
28 projects .
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1 (d) Had Daou reported revenue in line with the amount it was entitled to bill 2 customers pursuant to its contracts , actually reflecting contract work done to date, revenue would 3 have been $25.8 million, 8% less than publicly reported ($28.0 million). CW13, CW17, and CW27
4 confirmed that the dramatic growth in Daou's work in progress account, increasing $2.2 million from 5 1 Q98 to 2Q98 , was the result of defendants' premature recognition of revenue . The work in progress 6 account was comprised almost entirely of contract amounts Daou had recognized as revenue but fo r 7 I which it was not entitled to bill because little or no labor had yet taken place and the percentage o f 8 the project actually complete was lower than the percentage completion numbers defendants used to 9 calculate reported revenue .
10 (e) The reported increase in revenue during 2Q98 was attributable to defendants'
11 improper recognition of revenue, not "strong demand . At least 8% of Daou's publicly reported
12 revenue for 2Q98 was the result of prematurely recognizing revenue without any basis in actual labor 13 costs incurred or actual total estimated labor costs .
14 (f) According to CW24, in 1Q98 and into 2Q98 Daou recognized revenue on a
15 $2,000,000 call center project with the University of Chicago, when no contract had been signed .
16 According to CW24, McNeill closely monitored the University of Chicago project and knew that the
17 strategic plan for implementing the project was not completed until April 1998 and, as of June 30,
18 1998 (2Q98), Daou and the University of Chicago still had not agreed on the terms of the project.
19 Later in the project, when CW24 submitted a job costing sheet detailing labor costs incurred, she was
20 told by Field Services department executives, operating under McNeill, that the project had bee n
21 "closed" for billing purposes, even though the project was not close to completion .
22 (g) CWI, who received and entered POC data in the Company's ManFac t
23 accounting system, stated that in 1Q98 and 2Q98 Daou had recognized 100% of the revenue on the
24 Company's St. Mary's Health Network project, but that Field Services continued to submit job costing
25 sheets, because the project was not 100% complete . According to CW 1, approximately $4 million
26 in labor costs were incurred after Daou had recognized 100% of the revenue from the St. Mary's
27 Health Network contract.
28
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1 (h) Defendants' statements about Daou's 2Q98 revenue were also false because, 2 I1 in addition to the immediate recognition of revenue after a contract was signed or equipment wa s 3 ordered (and at a time when little or no labor costs had been incurred), defendants manipulated the 4 actual labor costs incurred and estimated total labor costs . According to CW12 and CW28, both
5 Field Services Engineers, the estimates of total labor costs provided by senior managers at project 6 sites were routinely ignored for revenue recognition purposes . The estimates of total labor hours 7 used to calculate revenue by defendants G. Daou, D. Daou, McNeill and McGee was, according to 8 CW12, grossly understated and did not reflect the opinions of the on -site managers . CW28 further 91 confirms that, during this period, he was told by Field Services Vice President Mirabile, who worked 10 at the direction of McNeill, what percent complete his projects were (for revenue recognition
11 purposes) and that these figures did not reflect the actual labor completed or labor required t o
12 complete the projects. According to CW28, based on his firsthand knowledge from Daou projects, 13 the actual percentage of completion numbers were adjusted upward by Daou's senior executives t o 14 ~ boost reported revenue.
15 (i) Daou was not on track to achieve FY98 EPS of $0.62 $0.64 or FY99 EPS of I
16 $0.90-$0.97, because defendants were prematurely recognizing revenue, in violation of GAAP and
17 the Company's stated accounting policy, on contracts that would take years to complete. As a result,
18 according to CW3 and CW24, project managers were told that projects were "closed" for billing
19 purposes, when the projects were actually far from completion . CW 17, a financial analyst in Daou's
20 San Diego headquarters, confirmed that, at the direction of McNeill, labor costs incurred after 100%
21 of the revenue was recognized were dumped into accounts receivable . After defendants finall y
22 reported Daou's disastrous 3Q98 results and revealed the financial impact of their accounting
23 manipulations, Daou reported a FY98 loss of $0 .33 per share. For FY99 Daou reported a loss of
24 $0.52 per share, nowhere close to the projected earnings of $0.90-$0.92.
25 (j) CW2, a training manager based in Daou's headquarters reported that he was
26 specifically told by both a senior-level network engineer and a Field Services project manager that
27 defendants' revenue recognition on their projects was improper and was not based on Daou's state d
28
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POC accounting policy . As a result, according to CW2, both the network engineer and project manager left Daou after making their complaints about improper revenue recognition . (k) Daou's work in progress account was p rimarily unbilled receivables, not hardware purchases for which no revenue had been recognized . CW4 and CW5 both confirm that Daou recognized a fixed percentage of revenue immediately upon ordering and receiving equipment
for a project. CW13 and CW17, as detailed above, further confirmed that the work in progress account was comprised almost entirely of contract amounts Daou had recognized as revenue but fo r
8 I which it was not entitled to bill because little or no labor had yet taken place and the percentage o f 9 the project actually complete was lower than the percentage completion numbers defendants used to 10 calculate reported revenue .
11 69. Defendants ` knowledge of falsity: Based on the reports of numerous witnesses, all 12 of whom were former members of Daou's Executive, Accounting or Field Services staff, defendants
13 not only knew that the Company's repo rted financial results and earnings forecast were based on
14 fraudulent accounting, but personally directed the violations of GAAP in order to artificially inflate
15 I revenues.
16 (a) Defendants G. Daou, D. Daou, McNeill and McGee personally directed Daou's
17 recognition of revenue, financial repo rting and public statements . Not only were these four 18 defendants the top executives at Daou, but, according to CW23, a former executive assistant to one
19 of the defendants , the Company was run "top to bottom" by G. Daou and D . Daou, with the
20 assistance of McNeill and McGee . G. Daou and D. Daou, confirmed CW23, were particularly
21 concerned with the Company's revenue recognition and exceeding the Company's projected revenue
22 and earnings, and made the final decisions on POC accounting revenue to be recognized.
23 (b) CW13 confirmed that McNeill provided G . Daou and D. Daou with all raw
24 POC and revenue recognition figures and, together with McGee, they personally determined what
25 revenue Daou would publicly report . According to CW9, who reported to McNeill, McNeill, G .
26 Daou and D. Daou paid particularly close attention to the POC and revenue recognition numbers, and
27 were, with McGee, the only people at Daou who could determine how much revenue to publicl y
28
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I I report. CW 15 further confirmed that all decisions regarding recognition of revenue on Daou' s 2 contracts were made by McNeill, G. Daou and D. Daou. 3 (c) CW9, a regional Sales Vice President at Daou, confirmed that defendants
4 G. Daou, D. Daou and McNeill not only made the decision on how much revenue to recognize . 5 without regard to any actual percentage of completion, but directed the practice of automatically
6 recognizing revenue upon contract signing and ordering of equipment. Accordingly, from their own 7 actions, these defendants knew their statements about Daou' accounting policy and revenue
8 recognition were false and misleading when made . 9 (d) CW19, a former Chief Information Officer with a large Midwestern health 10 services provider, confirmed that in 2Q98 he was personally contacted by G . Daou in an effort to get
11 a contract signed for a project in Michigan and that G . Daou desperately told CWI9 that Daou
12 "needed the business ." The contract was eventually awarded to one of Daou's competitors . 13 (e) According to CW 13, a former Daou Accounting Department Manager, in
14 I Q98 the Accounting Department, at McGee's direction, did a study of Daou's 100 largest contracts
15 to identify the discrepancies between revenue recognized and actual billing . For nearly every single
16 contract, the amount of revenue recognized greatly exceeded the amount that Daou could bill,
17 indicating revenue recognized out of line with the percentage, of the project actually completed .
18 CW 13 confirmed that the final report was provided to and discussed by G. Daou, D. Daou, McNeill,
19 McGee and Neil Cassidy.
20 (f) CW18, a finance consultant at Daou, confirmed that during 1Q98 and 2Q98,
21 and likely before, Neil Cassidy prepared a weekly update and forecast of actual versus projected
22 revenue and results, highlighting the gap between revenue that could properly be recognized and the
23 amount of revenue necessary to meet or exceed projections reported by analysts covering Daou .
24 According to CW 18, who worked with Cassidy, Cassidy's weekly report was distributed to Daou' 25 senior management, D. Daou, G. Daou, McNeill and McGee. 26 (g) As identified by CW24 and described above, McNeill closely monitored the
27 University of Chicago project and knew, in 2Q98, when revenue was recognized, that the strategi c
28
_80- 98cv1537-L(CGA) 0 LI
1 plan for implementation was not complete and Daou and the University had not agreed on terms for 2 the project.
3 (h) CW17 was hired by Daou in late 1998 to assist in reconciling the Comp any's 4 work in progress account with "unearned revenue" recognized in 1Q98 and 2Q98. According to 5 CW17, McGee and Daou's senior management knew that revenue had been booked without relation
6 to labor costs actually incurred or the percentage of a contract completed . CW 17 confirmed, based 7 on a review of Daou' 1Q98 and-2Q98 contracts, including the St . Mary's Hospital contract, that the 8 POC figures had been "massaged" in order to repo rt inflated revenue. 9 (i) Defendants knew that Daou had prematurely recognized 100% of the revenue 10 on projects that were not near completion. Between 1Q98 and 2Q98, Daou's accounts receivable 11 which defendants publicly reported and were aware of, increased $3 .43 million. According to CW 17,
12 a former financial analyst at Daou, defendants knew that the accounts rece ivable balance at Daou 13 represented labor costs incurred on a project after 100% of the revenue had been recognized under
14 POC accounting . CW 13 confirmed that defendants' premature recognition of 100% of the revenue 15 on contracts resulted in continuing labor costs being allocated to accounts receivable . 16 (j) All of the defendants knew how Daou's results were progressing in 2Q98 and 17 knew that the reported revenue could only be achieved by manipulating the Company 's financial 18 results. CWI, CW7, CW9, CW 12, CW17 and CW21 all confirm that both actual labor costs 19 incurred/completed and the estimates used to falsify Daou 's revenue recognition were recorded under
20 the direction of McNeill and distributed to G . Daou, D . Daou, McGee and periodically to directors, 21 including Moragne . Each employee on a Daou project was provided with a workbook containing the 22 template for an Excel spreadsheet . The spreadsheet (the job costing sheet) contained categories for 23 hours worked, along with travel and non-billable time. For each time period (initially Sunday to 24 Sunday, later changed to bi-weekly), the spreadsheet was provided to the project manager . The 25 project manager would compile the billable time, make an estimate , based on the time and costs 26 incurred to date , of the percent of the project that was complete and e-mail the information to Daou's 27 project cost accounting staff in San Diego, who operated under COO McNeill . CWI, a project cost 28 analyst, stated that the time and percentage of completion data was entered into the Company's
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1 ManFact accounting system. One or two days before the end ofthe month, Vice Presidents Ringwall 2 and Mirabile would print out the ManFact reports containing actual labor and percent completio n
3 submitted by project managers, for the current month and quarter . According to CWI, CW3, CW4, 4 CW7 and CW 16, the ManFact data was compiled into a Monthly Project Report which was sent to
5 G. Daou, D. Daou, McGee, and McNeill . The Monthly Project Report contained columns for 6 customer name, project number, contract amounts (total revenue dollars), amount of revenue 7 recognized in the six preceding months (identified by month), revenue to be recognized in the current
8 month, and a 12-month forecast of revenue available to be recognized (identified by month) . Based 9 on the comprehensive Monthly Project Report, G . Daou, D. Daou, McNeill and McGee would adjust 10 upward the percent completion for projects . According to CW1, who assisted in preparing the 11 Monthly Project Report, after senior management's (G . Daou, D. Daou, McNeill, McGee) initial
12 review of percentage of completion estimates, he would be directed by Ringwall or Mirabile to make 13 manual adjustments in the ManFact system to increase the percentage of completion estimates
14 submitted by project managers .
15 (k) CW 1 further confirmed that Vide President Neil Cassidy and Project Analyst
16 Wayne Walker would make jokes about the inflation of revenue recognition figures after defendants'
17 review of the Monthly Project Report . Likewise, CW3, CW9 and CW 27 confirmed that G . Daou,
18 D. Daou and McNeill monitored the actual and reported progress on POC contracts and it wa s
19 generally believed within the Company that they were improperly recognizing revenue without regard
20 to the actual status of ongoing projects .
21 (1) CW9 confirmed G . Daou and D. Daou were active, day-to-day managers of
22 the Company and routinely met with McNeill and McGee . G. Daou maintained his own project
23 accounts, including Western Tennessee Healthcare, Mercy Health Services and the Stanford Medical
24 Center. D. Daou oversaw mergers and acquisitions, using 6.6 million shares of Daou's artificially 25 inflated stock to acquire 11 companies during the Class Period . CW4 further confirms that G. Daou,
26 D. Daou and McNeill ran the day-to-day Field Services and Sales operations and McGee ran th e
27 Accounting Department .
28
-82- 98cv1537-L(CGA) 1 (m) During the conference call and subsequent conversations with analysts and
2 money and portfolio managers, defendants G. Daou, D. Daou, McGee and McNeill presented 3 themselves as the persons at Daou most knowledgeable about the Company's reported revenue, 4 earnings expectations, financial results and business . CW 14, a former analyst who covered Daou, 5 confirmed that these defendants, and in particular McGee, presented themselves as knowledgeable 6 about all aspects of the Company's finances, including earnings and revenue recognized under POC 7 accounting .
8 70. In June 1998, with Daou's stock trading at artificially inflated prices as a result of 9 defendants' false and misleading statements, defendants, led by D. Daou, acquired seven independent 10 companies - Technology Management, Inc., International HealthCare Systems, Inc., Resources in 11 HealthCare Innovations, Grand Isle Consulting, Inc ., Healthcare Transition Resources, Inc .,
12 Innovative Systems Solutions, Inc. and Ultitech Resources Group, Inc . - in exchange for'4 .23 million 13 shares of stock valued at $88,281,360. The same acquisitions, if done after the Class Period when
14 Daou's stock traded at an average of $5 .24 a share, would have required 19.6 million shares. 15 71. Defendants' false and misleading statements about Daou `s employee hiring and 16 retention and the nonexistent "Daou University" : Daou's ability to succeed and prosper as a 17 corporate developer, installer and operator of healthcare network systems was dependent on well- 18 trained and technologically-astute engineers and field operators, as well as a knowledgeable sales
19 staff. By 1997, the nationwide pool of highly trained and educated employees was drying up and 20 technology companies, particularly in California, were being impaired by insufficient employee hiring
21 and retention. Thus, throughout the Class Period, securities analysts and the market were particularly 22 concerned about Daou's ability to hire, train and retain the qualified engineers and employees 23 necessary to complete networking contracts and attract new business . Despite serious employee 24 issues at Daou which dramatically impacted the Company's business, defendants made the following 25 false and misleading statements during the Class Period:
26 (a) On April 29, 1997, Alex . Brown issued a "booster shot" research report on
27 Daou, based on information received from the Individual Defendants, rating the Company's shares
28 a "strong buy," in an attempt to boost Daou's stock price after it fell below its IPO price of $9 pe r
- 83 - 98cvl537-L(CGA) 0 L]
I share. Based on information from defendants, the report stated: "DAOU has been especially 2 successful in bringing on very experienced hires ." The report repeated that "[DaouJ attributes its
3 success in this area to its state-of-the-art training policies .. . and competitive compensation plan." 1 4 (b) On July 16, 1997, subsequent to the release of its 2Q97 results, Daou held a 5 conference call for analysts, money and portfolio managers, institutional investors and large 6 shareholders to discuss Daou's 2Q results, its business and its prospects . During the call, and in 7 follow-up conversations with analysts, G. Daou, D. Daou, McGee and McNeill stated:
8 Daou was successfully retaining employees and hiring new engineers and was more 9 than adequately staffed to support an expanding number of new customers . 10 Daou's new sales force hires were highly experienced and were adapting well. 11 (c) On October 15, 1997, subsequent to the release of its 3Q97 results, Daou held 12 a conference call for analysts, money and portfolio managers, institutional investors and large
13 shareholders to discuss Daou's 3Q results, its business and its prospects . During the call, and in 14 follow-up conversations with analysts, G. Daou, D. Daou, McGee and McNeill stated: 15 Daou was not having problems with employee turnover or attrition of engineers . 16 (d) On January 21, 1998, subsequent to the release of its 4Q and FY97 results, 17 Daou held a conference call for analysts, money and portfolio managers, institutional investors and 18 large shareholders to discuss Daou's 4Q and FY97 results, its business and its prospects . During the
19 call, and in follow-up conversations with analysts - G . Daou, D. Daou, McGee and McNeill stated : 20 Daou had 340 employees and headcount was expected togrow as employee turnover 21 continued to be low and Daou was attracting employees from its competitors .
22 (e) In May 1998, following the filing of the Company's I Q98 Form 10-Q,
23 defendants D . Daou and McGee made presentations at an Alex . Brown technology conference .
24 During a "breakout" session, in response to a question about employee training, D . Daou and McGee
25 stated that Daou University was a vibrant learning facility in San Diego where Daou employees
26 were taught new technical skills and became certified in new computer languages and programs .
27 D. Daou and McGee explained that Daou had an ongoing program with the local universities in San
28 Diego whereby Daou brought in college students to "Daou University" in order to teach them system s
-84- 98cv1537-L(CGA) L:J
1 and networking. McGee commented that many college students in San Diego would love to work 2 for Daou and Daou University was creating a great pool of new recruits through the Company's 3 alliance with San Diego colleges . 4 (f} On March 20, 1998, H&Q analyst D . Godsey visited Daou headquarters and 5 met with Daou management, including G . Daou, D. Daou and McGee. During the visit, defendants 6 told Godsey that Daou's professional retention rate was 90%+ . On March 23, 1998, H&Q issued a 7 report on Daou written by Godsey which repeated defendants' statement that Daou maintained a
8 90%+ professional retention rate . 9 (g) On July 29, 1998, subsequent to the release of its 2Q98 results, Daou held a 10 conference call for analysts, money and portfolio managers, institutional investors and large 11 shareholders to discuss Daou's 2Q results, its business and its prospects . During the call, and in 12 follow-up conversations with analysts - G . Daou, D. Daou, McGee and McNeill stated: 13 Daou Is employee turnover remained very low and attrition within the technical 14 ranks of employees was only 6.8%. 15 72. As a result ofthese false and misleading statements, Daou's stock price was artificially 16 inflated throughout the Class Period.
17 73 . Reasons why defendants' statements about Daou's employee hiring and retention 18 and "Daou University" were false and misleading : Defendants' statements about "success" in 19 hiring and retaining experienced employees, low employee turnover and "Daou University" were false 20 and misleading when made. The following facts, corroborated by at least six confidential witnesses, 21 including human resources, engineering and executive personnel based in Daou's San Diego 22 headquarters and at specific Company projects confirm that Daou was suffering from employee 23 turnover exceeding 40% and could not attract appropriately trained personnel and that "Daou 24 University" did not exist .
25 (a) According to CW2, a Technical Training Manager at Daou during the Class
26 Period, Daou's public statements about its employee hiring, retention and training were false .
27 Employee turnover, especially among the Field Services engineers, exceeded 40%. Moreover,
28 according to CW2, no funding was provided for employee training. As a result, personnel were sent
-85- 98cv1537-L(CGA) U
1 to projects without the qualifications to operate Daou's network systems . CW19 confirmed that, for 2 example, in 1Q97, Daou sent a "PC Technician" and a "Sr . Engineer" to Mercy Health Services to
3 work full-time in the customer's networking department . Neither person had any technical or 4 engineering training and they could not even operate Windows 95. The Daou "specialists" had to 5 attend Mercy's Windows 95 training with Mercy's own employees.
6 (b) CW8 . and CW26, both Field Service Engineers, confirmed that employee 7 turnover at Daou was at least 30%-40% and that Daou could not retain qualified engineers because 8 of low pay, no training and excessive travel. As a result unqualified personnel were sent to job sites 9 and Daou could not adequately staff its projects . 10 (c) According to CW2 and CW3, in 1 Q98 Vice President of Human Resources 11 Dan Porter admitted internally to them and others that Daou's employee turnover rate exceeded 40%,
12 not 6.8%, and that Daou could not adequately address staffing problems at the Company's projects . 13 (d) In addition to a lack of funding for in-house training, no former company 14 employee, including those who worked with Daou's executives and in human resources, had ever
15 heard of "Daou University" and no former employee believed that "Daou University" existed . CW2 16 confirmed that Daou had no in-house training program whatsoever and, according to CW21, the 17 Company was hiring, among others, untrained mechanics and cable pullers as computer technicians, 18 not college graduates.
19 74. Defendants' knowledge of falsity: Based on the reports of numerous witnesses, all
20 of whom were former members of Daou's Human Resources, Field Services or executive staff,
21 defendants knew throughout the Class Period that Daou was suffering from employee retention and
22 hiring problems and defendants had no basis to believe that Daou University existed . According to
23 CW2 and CW3, Daou's problems with hiring and retaining qualified employees was well-known
24 throughout the Company . CW19 confirmed that, with regard to staffing problems at Daou's Mercy
25 Health Services project, he personally spoke with G . Daou and noted that the staffing being provided
26 was insufficient and untrained . CW2 confirmed that Daou's senior management, including G . Daou,
27 D. Daou and McNeill, set the budget, or lack thereof, for in-house training and knew it was not
28 adequate. CW3, CW8 and CW19 further confirmed that Dan Porter, the Vice President of Huma n
-86- 98cvl537-L(CGA) L' L]
Resources who acknowledged at Company meetings that turnover was exceeding 40%, met with G . Daou, D. Daou, McNeill and McGee on a weekly basis to review Daou's business status, prospect s ( and problems.
75. Defendants 'false and misleading statements about Daou's customers, contracts and pipeline and backlog:
(a) On April 21, 1997 subsequent to the release of its 1Q97 results, Daou held a 7 conference call for analysts, money and portfolio managers, institutional investors and large 8 shareholders to discuss Daou 's results, its business and its prospects . During the call, and in follow- 9 up conversations with analysts, G. Daou, D. Daou, McGee and McNeill stated: 10 • Daou had an extremelystrong backlog of$63 million and pipeline of orders, which
11 would lead to continued strong revenue and earnings growth in 1997 and 1998 .
12 • Daou saw significant increases in new business on all fronts and repeat business 13 from existing clients with excellent visibility going forward . 14 (b) On April 29, 1997, Alex . Brown & Sons, Inc. ("Alex. Brown") issued a 15 "booster shot" research report on Daou, based on information received from the Individual
16 Defendants, rating the Company's shares a "strong buy," in an attempt to boost Daou's stock price
17 after it fell below its IPO price of $9 per share . Based on information from defendants, the report
18 stated: "DAOU benefits from an extremely strong backlog and pipeline position," By June 13,
19 1997, when Alex. Brown issued its next research report on Daou, reiterating its "strong buy" rating,
20 Daou's stock price had increased to $13 per share, and Alex . Brown raised its 12-month price target
21 for Daou stock from $11 to $16 per share .
22 (c) On October 15, 1997, subsequent to the release ofits 3Q97 results, Daou held
23 a conference call for analysts, money and portfolio managers, institutional investors and large
24 shareholders to discuss Daou's results, its business and its prospects . During the call, and in follow-
25 up conversations with analysts - G . Daou, D. Daou, McGee and McNeill stated : 26 • Backlog was now $26 7 million, up from $10 million in 1Q97 and $20 million in
27 2Q97, and visibility was excellent.
28
-87- 98cv1537-L(CGA) E l.~.J
1 Daou's order pipeline and acquisition pipeline remained healthy and would fuel 2 future earnings growth .
3 (d) On January 21, 1998, subsequent to the release of its 4Q and FY97 results,
4 Daou held a conference call for analysts, money and portfolio managers, institutional investors and
5 large shareholders to discuss Daou's 4Q and FY97 results, its business and its prospects. During the
6 call, and in follow-up conversations with analysts, G. Daou, D . Daou, McGee and McNeill stated:
7 Backlog had jumped to $42 .9 million and the order pipeline provided tremendous
8 visibility into 1998 and 1999 revenue and earnings growth , with 81 % of expected 1998
9 revenue already booked.
10 (e) On April 23, 1998, subsequent to the release of its 1 Q98 results, Daou held 11 a conference call for analysts, money and portfolio managers, institutional investors and large Daou 12 shareholders to discuss Daou's results, business and prospects . During the call, and in follow-up 13 conversations with analysts, G. Daou, D. Daou, McGee and McNeill stated: 14 Daou was successfully adding new customers and its momentum was increasing. 15 Backlog was strong with a total of $84 million in backlog, and the core pipeline 16 reached $152 million. 17 (1) On July 29, 1998, subsequent to the release of its 2Q98 results, Daou held a 18 conference call for analysts, money and portfolio managers, institutional investors and large
19 shareholders to discuss Daou's 2Q results, its business and its prospects . During the call, and in 20 follow-up conversations with analysts - G . Daou, D. Daou, McGee and McNeill stated : 21 Backlog was strong, totaling $98 .5 million with $56 million over the next 12 months 22 and $34 million over the next six months and the core order pipeline stood at $182 million .
23 Visibility of future earnings was outstanding.
24 76. Reasons why defendants' statements about Daou 's customers, contracts and
25 pipeline and backlog were false and misleading: Defendants' repeated statements about Daou's
26 "extremely strong backlog and pipeline position" and attributions of "outstanding" future demand,
27 earnings and revenue to the Company's pipeline position were false and misleading when made. The
28 following facts, corroborated by at least six confidential witnesses, including Accounting, Fiel d
_88- 98cv1537-L(CGA) E
I Services and executive personnel based in Daou's San Diego headquarters and at specific Company
2 projects, confirm that Daou's backlog and pipeline claims were not based on any actual contractual 3 demand and were highly speculative, at best . 11 4 (a) According to Sales Vice President CW9 and CW20, by 2Q97 Daou was
5 suffering from a lack of new sales and contract signings. During this period, Daou's seven regional 6 sales vice presidents were unable to meet the projected quarterly sales quota and there was little new 7 business development. The pipeline figures, promoted to analysts as a measure of Daou's business 8 expansion, were highly speculative and not indicative of existing demand for Daou's services . CW1 9 confirmed that defendants' statements were based on the monthly "Pipeline Report" prepared by Neil 10 Cassidy at the direction ofMcNeill, which listed existing and prospective contracts, the potential sales 11 revenue involved and the probability of closing the sale . The "revenue" listed in the report and 12 provided to analysts and the market was, according to CW9, automatically set at 20% of a contract's 13 total value if a Daou salesperson had even met with the prospective client to discuss a deal, 50% if 14 Daou had submitted a deal proposal, 70% if Daou had submitted a formal bid on the deal, 90% if
15 Daou "appeared to have won" but the deal was not formally closed and 100% when the sale was 16 formerly closed. The pipeline figure, despite defendants' representations, did not actually reflect 17 contracts Daou would actually get, and included millions of dollars on projects that Daou had little 18 or no chance of actually doing.
19 (b) The likelihood of Daou getting repeat business from current customers was
20 low. According to CW20, CW22 and CW24, Daou's primary customers, including Mercy Health
21 Services, Huntington Memorial Hospital, the University of Chicago and St . Agnes Health Center
22 were all complaining in 1997 and early 1998 about overdue and overbudget projects and Daou's
23 inability to provide adequate staffing. In the case of both Mercy Health Services and Huntington
24 Memorial Hospital, Daou failed to provide the on-site engineers required under the terms of the
25 contracts and, according to CW3, unqualified "technicians" were sent to most of Daou's ongoing
26 projects because of the Company's high employee turnover.
27• 77. Defendants' knowledge of falsity : Based on the reports of numerous witnesses, all 28 of whom were former members of Daou's Field Services or executive staff, defendants kne w
-89- 98cvl537-L(CGA) 0
I throughout the Class Period that Daou's vaunted backlog and pipeline figures were arbitrarily 2 determined with no basis in fact and did not represent purported strong growth or momentum . 3 (a) According to CW 1 and CW 1, Daou's seven regional sales vice presidents held 4 a weekly or biweekly conference call with McNeill to update McNeill on the status or outlook of
5 prospective projects. Based on these calls and follow-up conversations with the regional vice 6 presidents, McNeill directed Neil Cassidy to prepare a monthly Pipeline Report. The Pipeline Report 7 contained the arbitrary determination of future business based on fixed percentages of proposed 8 contracts' value. According to CW 1 and CW 17, the Pipeline Report was distributed, at the end of 9 each calendar month, to G. Daou, D. Daou, McNeill and McGee. The arbitrary determination of 10 "revenue" allocated to the pipeline was made by G . Daou, D. Daou, McNeill and McGee. 11 (b) CW9 further confirmed that after the distribution of the quarter-end Pipeline
12 Report, Daou's sales and field services vice presidents met in San Diego with D . Daou, G. Daou, 13 McNeill, McGee, Ringwall and Dan Porter to discuss both actual and reported revenue, as well as 14 the purported pipeline . 15 (c) During the conference call, and subsequent conversations with analysts and 16 money and portfolio mangers, defendants D . Daou, G. Daou, McNeill and McGee presented 17 themselves as the persons at Daou most knowledgeable about the Company's purported pipeline . 18 THE REVELATION OF ADVERSE FACT S
19 78. On August 13, 1998, the Company filed its report on Form 10-Q with the SEC signed
20 by defendants D . Daou and McGee, and the impact of defendants' financial shenanigans began to leak
21 out. In its Form 10-Q, the Company reported figures that were entirely different than what
22 defendants had stated just two weeks earlier in Daou's July 29, 1998 press release and conference call
23 to analysts. Although the Company had represented in its July 29, 1998 press release that earnings
24 excluding merger charges were $0 .12 and that its general and administrative expenses for the second
25 quarter were $2.34 million and its merger expenses were $2 .9 million, its Form 10-Q revealed a
26 different story . According to its Form 10-Q, the Company's general and administrative expenses were
27 actually $3 .54 million while merger-related expenses were only $1 .02 million, revealing that the
28 Company's operating income expenses before merger was only $0 .08, or 33% less than originall y
-90- 98cv1537-L(CGA) E 1. J
I reported. Defendants had been aware of this information two weeks earlier when they reported the
2 false figures to analysts and the investing public. Defendants failed to disclose the actual figures to 3 analysts to conceal the fact that Daou's operating earnings and margins were deteriorating as a result 4 of prematurely and improperly recognizing revenue . Despite these changes, defendants again
5 represented that "[t]hese financial statements reflect all adjustments, consisting of only normal 6 recurring adjustments, which in the opinion of management are necessary to fairly present the 7 financial position of [Daou] at June 30, 1998 and the results of operations for the three and six-month 8 periods ended June 30, 1998 and 1997." 9 79. In response to these disclosures, analysts were outraged about being misled. As one 10 analyst noted, "[w]hen you say one thing on the conference call and report something different on the 11 10-Q, that raises concern. . . . You have gotto question whether they are manufacturing earnings ." 12 80. Not surprisingly, the market reacted dramatically to these discrepancies. On the day 13 following the revelation, the Company's stock price fell $5 .75 per share to $12 .75 in heavy trading, 14 but continued to trade at artificially inflated levels through the remainder of the Class Period due to
15 defendants' continued false statements . 16 81 . During the following weeks, amid negative rumors and speculation, defendants 17 steadfastly maintained that Daou's financial statements were accurate and that its business
18 fundamentals and momentum remained intact . 19 82. Finally, on October 28,1998, Daou reported such extremely poor results for the 3Q98 20 that defendants' credibility was completely lost . Daou reported revenues of only $27 .4 million, a loss
21 of $3 .1 million or $0.17 per share, accounts receivable of $30.5 million and contract work in progress 22 of $12.3 million. Operating margin was a negative 17 .2%. Defendants blamed the poor results on 23 delays in the signing of projects totaling approximately $42 million, $4 million of which was expected
24 to be booked as revenue during Q3.. Defendants disingenuously blamed these delays on negative 25 publicity. In the conference call with analysts, defendants conceded the following points : 26 Daou's general and administrative costs increased $2 million over the 2Q98 figure, 27 which latter figure Daou claimed included a million dollars of one-time expenses, implying 28 that the general and administrative cost figure effectively increased by $3 million sequentially .
- 91 - 98cv1537-L(CGA) L]
1 General and administrative costs, as a percentage of revenues, had swollen to 21 % in 2 3Q98, compared with only 14% in 3Q97 .
3 • Accounts receivable measured in days' sales outstanding ballooned to 105 days versus
4 71 days in 2Q98 .
5 • Daou had to record $400,000 in additional accounts receivable reserves in 3Q98 . 6 • Daou claimed to have reduced its contract work in progress account some 50% by 7 accelerating billing milestones, thereby reducing unbilled receivables by some $10 million, 8 which flatly contradicted Daou's prior statements that unbilled receivables represented only 9 $900,000 of contract work in progress. 10 83 . As a result of these announcements, the market finally understood that it was all a big
11 lie. Daou's stock dropped to as low as $3 .25 on volume of 3 .2 million shares, more than a 90% 12 decline from the Class Period high of $34 .375 .
13 84. Daou ultimately reported a 1998 loss of $0.33 per share versus Class Period estimates 14 of earnings of $0 .50-$0.67, and a FY99 loss of $0.52 per share versus Class Period estimates of 15 $0.90-$0.97. In response to analyst outrage and this litigation, Daou also announced that it was
16 moving its business practice away from fixed-price contracts to charging on a time and expense basis, 17 in an attempt to make its business profitable . As the chart set forth below demonstrates, Daou has 18 never recovered from defendants' fraud and, without artificially inflated revenue, has never come close
19 to actually achieving the revenues reported during the Class Period .
20
21
22
23
24
25
26
27
28
-92- 98cv1537 -L(CGA) 1 Daou Systems, Inc . February 13,1997 - May 14, 2002 2 Daily Share Prices 3 40
4 5 30 6 7 vt N 8 20 iA 9 0 c 10 10 11 12 13 0 14 02113/1997 1010611997 0512911998 01120/1999 09/10/1999 05/0212000 1212012000 0811412001 04/121200 2 06/11/1997 02/02/1998 09/23/1998 05117/1999 0110512000 08125/2000 04/19/2001 12113/200 1 15
16 CLASS ACTION ALLEGATION S 17 85. Plaintiffs bring this action as a class action pursuant to Federal Rule of Civil 18 Procedure 23(a) and (b)(3) on behalf of a class consisting of all persons who purchased or acquired
19 shares of Daou common stock (the "Class") from February 13, 1997 through October 28, 1998, 20 inclusive, and who were damaged thereby. Excluded from the Class are the defendants, officers and 21 directors ofthe Company, members of their immediate families and their legal representatives, heirs, 22 successors or assigns and any entity in which defendants have or had a controlling interest . 23 86. The members of the Class are so numerous that joinder of all members is
24 impracticable. The disposition of their claims in a class action will provide substantial benefits to the 25 parties and the Court. As of March 6,1998, Daou had approximately 11,826,654 shares of common 26 stock outstanding, owned by thousands of shareholders . Record owners and other members of the 27 Class may be identified from records maintained by Daou or its transfer agent and may be notified o f
28
-93 98cv1537-L(CGA) LI
1 the pendency of this action by mail, using the form of notice similar to that customarily used in 2 securities class actions .
3 87. Plaintiffs' claims are typical of the claims of the members of the Class as all members 4 of the Class are similarly affected by defendants' wrongful conduct in violation ofthe federal law that 5 is complained of herein .
6 88. Plaintiffs will fairly and adequately protect the interests of the members of the Class
7 and has retained counsel competent and experienced in class and securities litigation. 8 89. There is a well-defined commonality of interest in the questions of law and fact 9 involved in this case . The questions of law and fact common to the members of the Class which 10 predominate over questions which may affect individual Class members include : 11 (a) Whether the federal securities laws were violated by defendants ; 12 (b) Whether defendants omitted and/or misrepresented material facts ; 13 (c) Whether defendants participated in and pursued the common course of conduct 14 complained of herein, specifically, whether defendants misstated the financial results ofthe Company
15 in public statements including press releases and filings with the SEC, in direct contravention of 16 GAAP; 17 (d) Whether documents, press releases and other statements disseminated to the 18 investing public and the Company's shareholders during the Class Period misrepresented and/or 19 omitted material facts about the business, financial condition, and future business prospects ofDaou ; 20 (e) Whether defendants acted with scienter in knowingly or recklessly omitting
21 and/or misrepresenting material facts regarding the financial state of the Company , 22 (f) Whether the market price of Daou common stock during the Class Period was 23 artificially inflated due to the material misrepresentations and failure to correct the material
24 misrepresentations complained of herein; and 25 (g) The extent of damages sustained by Class members and the appropriate 26 measure of damages.
27 90. Plaintiffs will rely, in part, upon the presumption of reliance established by the fraud-
28 on-the-market doctrine in that :
-94- 98cv1537-L(CGA) 0 0
1 (a) Defendants made public misrepresentations or omitted material facts during 2 the Class Period, as alleged herein ;
3 (b) The misrepresentations and/or omissions were material ; 4 (c) Daou's common stock was traded in an efficient market; 5 (d) The misrepresentations and/or omissions alleged tended to induce reasonable 6 investors to misjudge the value of Daou shares ; and 7 (e) Plaintiffs and members of the Class acquired their shares between the time 8 defendants made the misrepresentations and/or omissions and the time the truth was revealed, without
9 knowledge of the falsity of the misrepresentation. 10 91 . Based upon the foregoing, plaintiffs and the other members of the Class are entitled 11 to a presumption of reliance upon the integrity of the market for, at least, the purposes of class 12 certification, as well as for ultimate proof of the claims on their merits, Similarly, plaintiffs and the 13 members of the Class are entitled to a presumption of reliance with respect to the omissions alleged 14 herein. 15 92, A class action is superior to all other available methods for the fair and efficient 16 adjudication of this controversy . Furthermore, as the damages suffered by individual Class members 17 may be relatively small, the expense and burden of individual litigation makes it impossible for 18 members of the Class to individually redress the wrongs done to them . There will be no difficulty in
19 the management of this class action. 20 STATUTORY SAFE HARBOR 21 93 . The statutory safe harbor provided for forward-looking statements under certain 22 circumstances does not apply to any of the allegedly false forward-looking statements pleaded in this 23 complaint because the statutory safe harbor does not apply to Daou's financial statements and because 24 none of the particular oral forward-looking statements pleaded herein was identified as "forward- 25 looking statements" when made . None of the written forward-looking statements made was 26 identified as forward-looking statements . Nor was it stated as to either type of forward-looking 27 statement that actual results "could differ materially from those projected ." Nor did meaningful 28 cautionary statements identifying important factors that could cause actual results to differ materiall y
_95- 98cv1537-L(CGA) 0 U
1 from those in the forward-looking statements accompany those forward-looking statements . In any 2 event, each of the forward-looking statements alleged herein was authorized by an executive officer
3 of Daou, and was actually known by each of the Individual Defendants to be false when made . 4 FIRST CLAIM FOR RELIEF 5 For Violations of Section 10(b) of the Exchange Act and Rule lOb-5 Promulgated Thereunder Against All Defendants 6 94. Plaintiffs incorporate ¶11-93 . 7 95. During the Class Period, defendants, and each ofthem, carried out a plan, scheme and 8 course of conduct which was intended to and, throughout the Class Period, did : (i) deceive the 9 investing public, including plaintiffs and the other Class members, as alleged herein ; (ii) artificially 14 inflate and maintain the market price of Daou securities; and (iii) cause plaintiffs and other members 11 of the Class to purchase Daou securities at inflated prices . In furtherance of this unlawful scheme, 12 plan and course of conduct, defendants, and each of them, took the actions set forth herein . 13 96, Defendants (a) employed devices, schemes, and artifices to defraud ; (b) made untrue 14 statements of material fact and/or omitted to state material facts necessary to make the statements 15 made not misleading; and (c) engaged in acts, practices, and a.course of business which operated as 16 a fraud and deceit upon the purchasers of the Company's stock in an effort to maintain artificially high 17 market prices for Daou's securities in violation of § 10(b) of the Exchange Act and Rule I Ob-5. 18 97. The statements made by defendants during the Class Period were materially false and 19 misleading because at the time they were made, defendants knew or recklessly ignored, but failed to 20 disclose, the matters set forth herein . 21 98. In ignorance of the artificially inflated market prices of Daou's publicly traded 22 securities, and relying directly on defendants or indirectly on the false and misleading statements made 23 by defendants, upon the integrity of the market in which the securities trade, on the integrity of the 24 regulatory process and the truth of any representations made to appropriate agencies at the time of 25 the public offering and/or on the absence of material adverse information that was known to 26 defendants but not disclosed in public statements by defendants during the Class Period, plaintiffs and 27 the other members of the Class acquired Daou securities during the Class Period at artificially high 28 prices and were damaged thereby.
-96- 98cv1537-L(CGA) v •
1 99. Had plaintiffs and the other members of the Class and the marketplace known the trut h
2 . about the true financial condition and business prospects of Daou, which were not timely disclosed 3 by defendants, plaintiffs and other members of the Class would not have purchased or otherwise 4 acquired their Daou securities during the Class Period, or, if they had acquired such securities during 5 the Class Period, they would not have done so at the artificially inflated prices which they paid . 6 Hence, plaintiffs and the Class were damaged by defendants' violations of § 10(b) and Rule 1 Ob-5 . 7 100. As a direct and proximate result of defendants' wrongful conduct, plaintiffs and the
8 other members of the Class suffered damages in connection with their purchases of the Company' s
9 I securities during the Class Period .
10 SECOND CLAIM FOR RELIE F
11 For Violation of Section 20(a) of the Exchange Act Against Defendants Daou, G . Daou, 12 D. Daou, McGee and McNeill
13 101 . Plaintiffs incorporate $11-100 . Plaintiffs assert this claim against Daou, G. Daou,
14 D. Daou, McGee and McNeill. These defendants acted as controlling persons of Daou within the
15 meaning of §20 of the Exchange Act as alleged herein . By virtue of their executive and directorial
16 positions, their knowledge and involvement in the day-to-day business ofDaou, including its financial
17 reporting, their stock ownership, and their power and ability to make public statements on behalf of
18 Daou to shareholders, potential investors and the media, defendants had the power and ability to
19 control the actions of Daou .
20 102. By reasons of wrongful conduct, defendants are liable pursuant to §20(a) of the
21 Exchange Act. As a direct and proximate result of defendants' wrongful conduct, plaintiffs and the
22 other members of the Class suffered damages in connection with their purchases of the Company' s
23 securities during the Class Period.
24 THIRD CLAIM FOR RELIEF
25 For Violation of Section 11 of the Securities Act Against Defendants Daou , G. Daou, 26 D. Daou, McGee and Moragne
27 103 . Plaintiffs incorporate IM 1-102 .
28
-97- 98cvl537-L(CGA) 0 0
104. This Claim is brought pursuant to §11 of the Securities Act, 15 U .S .C. §77k, by plaintiffs on behalf of that portion of the Class that acquired Daou common stock issued pursuant to
the Registration Statement effective February 13, 1997, against defendants Daou, G . Daou, D. Daou, McGee and Moragne.
105. The Registration Statement issued by Daou was inaccurate and misleading, contained
I untrue statements of material facts, omitted to state other facts necessary to make the statement s 7 made not misleading and failed to adequately disclose material facts, as is described above . 8 106. Daou is the issuer of the stock sold via the Registration Statement . As issuer of the 9 shares, Daou is strictly liable to plaintiffs and that portion of the Class that purchased shares issued 10 pursuant to this Registration Statement, for the material misstatements and omissions therein.
11 107. The Individual Defendants named in this Claim each signed the Registration
12 Statement. None of the defendants named herein made a reasonable investigation or possessed
13 reasonable grounds for the belief that the statements contained in the Registration Statement were
14 true, did not omit any material fact and were not misleading .
15 108. Each of the defendants named in this Claim issued, caused to be issued an d
16 participated in the issuance of materially false and misleading written statements to the investing
17 public which were contained in the Registration Statement, which misrepresented or failed to disclose,
18 inter alia, the facts set forth above . As a direct and proximate result of defendants' acts an d
19 omissions in violation of the Securities Act, the market price of Daou stock was artificially inflated,
20 and plaintiffs and other Class members suffered substantial damage in connection with their
21 acquisition of Daou common stock issued pursuant to the Registration Statement. By reasons of the
22 conduct herein alleged, each defendant named in this Claim violated, and/or controlled a person who
23 violated, § 11 of the Securities Act.
24 109: At the times they acquired Daou shares, plaintiffs and other members ofthe Classwer e 25 without knowledge of the facts concerning the false or misleading statements or omissions alleged
26 herein. Less than one year elapsed from the time that plaintiffs discovered or reasonably could have
27 discovered the facts upon which this Complaint is based to the time of the filing of this action . Less
28
-98- 98cv1537-L(CGA) ►.__J
1 than three years have elapsed from the time that the securities upon which this Claim is brought were
2 bona fide offered to the public, to the time of the filing of this action. 3 FOURTH CLAIM FOR RELIEF
4 For Violations of Section 12(a)(2) of the Securities Act Against Defendants Daou, 5 G. Daou, D. Daou, McGee and Moragne
6 110. Plaintiffs incorporate ¶¶1-149 ..
7 111. This Claim is brought pursuant to §12(a)(2) of the Securities Act, 15 U.S .C. 8 §771(a)(2) by plaintiffs on behalf of that portion ofthe Class that acquired Daou common stock issued
9 pursuant to the Registration Statement effective February 13, 1997 against defendants Daou, G . 10 Daou, D. Daou, McGee and Moragne .
11 112. Defendants Daou, G . Daou, D. Daou, McGee and Moragne were solicitors of sales
12 of the shares offered and sold in connection with the February 13, 1997 Registration Statement and
13 Prospectus.
14 113. The actions of solicitation taken by the defendants named in this Claim included 15 participation in the preparation and in the dissemination of the false and misleading Prospectus . The 16 written and oral communications made in connection with the Prospectus contained untrue statements 17 of material facts, omitted to state other facts necessary to make the statements made not misleading 18 and failed to disclose material facts . 19 114. Daou offered for sale the shares acquired by plaintiffs and other Class members . 20 115. Each defendant named in this Claim solicited and/or was a substantial factor in the
21 acquisition of Daou common stock by these members of the Class. But for the participation by these 22 defendants, including the solicitation by these defendants as set forth herein, the wrongful conduct 23 11 alleged herein could not and would not have been accomplished. The defendants named herein
24 participated in the acts detailed herein as follows :
25 (a) They actively and jointly drafted, revised, and approved the Prospectus and
26 other written materials by which Daou shares were offered to plaintiffs and members of the Class .
27 These written materials were "selling documents," calculated by these defendants to create interest
28 in Daou common stock and were distributed by defendants for that purpose ; and
-99- 98cv1537-L(CGA) 0 a
I (b) They finalized the Registration Statement and Prospectus and caused it to 2 become effective .
3 116 . The defendants named in this Claim were obligated to make a reasonable and diligent 4 investigation ofthe written and oral statements made in the Prospectus, to insure that such statements 5 were true and that there was no omission to state a material fact required to be stated in order to 6 make the statements contained therein not misleading . 7 117. Plaintiffs and other members of the Class acquired Daou shares issued pursuant to the
8 defective Registration Statement and Prospectus, and were damaged thereby . These Class members 9 did not know, or in the exercise of reasonable diligence could not have known, of the untruths and
10 omissions contained in the Registration Statement and Prospectus . 11 118. By reason of the conduct alleged herein, these defendants violated, and/or controlled 12 a person who violated, § 12(a)(2) of the Securities Act . As a direct and proximate result of these 13 violations of § 12(a)(2), plaintiffs and the other members of the Class sustained substantial damage 14 in connection with the acquisition of Daou stock . 15 119. Less than one year has elapsed from the time that plaintiffs discovered or reasonably 16 could have discovered the facts upon which this complaint is based to the time of the filing of this 17 action. Less than three years has elapsed from the time that the securities upon which this Claim is
18 brought were sold to the public to the time of the filing of this action. 19 FIFTH CLAM FOR RELIEF 20 For Violation of Section 15 of the Securities Act Against Defendants Daou, G. Daou, D. Daou and McGee 21 120. P l a i n t i f f s Incorporate ¶ 11-119 . 22 121 . Plaintiffs assert this Claim against G. Daou, D. Daou and McGee. These defendants 23 acted as controlling persons of Daou within the meaning of § 15 of the Securities Act as alleged 24 herein. By virtue of their executive and directorial positions, their knowledge and involvement in the 25 business of Daou, their stock ownership, and their power and ability to make public statements on 26 behalf of Daou to shareholders, potential investors and the media, defendants had the power and 27 ability to control the actions of Daou, and exercised the same, to cause Daou to engage in the 28
- 100 - 98cv1537-L(CGA) C
1 violations of law complained of herein. These defendants are therefore liable under §15 of the 2 Securities Act. 3 122. Daou controlled each of the Individual Defendants named in this Claim and is liable
4 for their acts under § 15 of the Securities Act . 5 PRAYER FOR RELIEF
6 WHEREFORE, plaintiffs pray for judgment as follows: 7 1 . Declaring this action to be a proper class action pursuant to Rule 23(a) and (b)(3) of 8 the Federal Rules of Civil Procedure on behalf of the Class defined herein ; 9 2. Awarding plaintiffs and the members of the Class compensatory damages, including
10 rescission where applicable; I 1 3 . Awarding plaintiffs and the members of the Class pre judgment and post judgment
12 interest, as well as reasonable attorneys' fees, expert witness fees, and other costs ; 13 4. Awarding extraordinary, equitable and/or injunctive relief as permitted by law, equity 14 and federal statutory provisions sued hereunder, pursuant to Rules 64, 65 and any appropriate state 15 law remedies; and 16 5. Awarding such other relief as this Court may deem just and proper. 17 JURY DEMAND 18 Plaintiffs demand a trial by jury .
19 DATED: May 16, 2002 MILBERG WEISS BERSHAD HYNES & LERACH LLP 20 WILLIAM S. LERACH 21 JAN M. ADLER TOR GRONBORG 22 KAREN A. BATCHER
23 24 JAN M. ADLER
25 401 B Street, Suite 170 0 26 San Diego, CA 92101 Telephone: 619/231-1058
27 Lead Counsel for Plaintiffs 28 N:U:ASES\DAOU\ThudAmcnded.cpt
- 101 - 98cv1537-L(CGA) 0 w I .. 0 al APPENDIX A Daou Systems, Inc.
Lead Shares Share Total i ate PurcaseA Price Loss De Kruyff, Patrick 06/25/98 2000 $21 .000 2000 ($27,848,00) 1
Ford, Rod 11/12/97 250 $16.50 Ford Rod 03/03/98 500 $26.50 Ford Rod 03/18/98 500 $19.00 Ford Rod 03/23/98 250 $19.00 1500 $21,011 .00
Haman, Thomas V. 07/28/98 1000 $20.00 Hagman, Thomas V. 08/14/98 j" $14.88 2000 ($20,723.00)
Krabbenhoft, Eu ene 03/18/98 1000 $26.75 Krabbenhoft, Eugene 03/30/98 400 $18.75 Krabbenhoft, Eugene 04/30/98 1000 $18.75 Krabbenhoft, Eugene 05/04/98 0 0 $16.50 3400 $47,441 .64
Rabin, Paul 02/13/97 3000 $9.375 Rabin, Paul 3000 ($1,500.00)
S arlin , Greg 01/22/98 1,000 $24.375 S arlin Greg 01/29/98 1,000 $22.500 Spariing, .Greg 03/19/98 1,000 $20.375 Spading, Greg_ 03/19/98 2,000 $21 .000 Spading,, Greg 04/29198 1,000 $18.125 S ailing, Greg 05/05/98 1,000 $17.250 S arlin Greg 05/07/98 4,000 $16.500 Sperling, Greg 05/22/98 1,500 $18.000 S arlin , Greg 05/22/98 2,000 $17.81 3 S arlin , Greg 05/22/98 1,500 $17 .875 Spading, Greg 05/27/98 3,000 $16 .438 Sperling, Greg 06/09/98 1,000 $15 .625 S arlin , Greg 06/10/98 1,000 $15.750 S arlin , Gre 06/11/98 1,000 $15.250 S ariin , Gre 06112/98 1,000 $14.000
APPNDIx A 9 el APPENDIX A Daou Systems, Inc.
Lead Shares Share Total Plaintiff pate Purchased Price Lost S ariin , Gre 07/01/98 1,500 $20.875 Spatting, Greg 07101/98 1,500 $21 .000 Sparring, Greg 07/07/98 3,000 $18.375 S ariin , Greg 07130198 1,000 $20.750 Sparring, Gre 08/03/98 3,000 $18.500 S arlin Greg 08/04198 3,000 $17.625 S actin Greg 08/06/98 1000 $18.750 S pardin , Greg 08/06/98 1 000 $18.500 Spirting, Greg 08/10/98 2,000 $18.938 Spading, Greg 08/12198 2,000 $18.500 S arlin , Greg 08/13/98 500 $18.500 Spading, Greg 08/14/98 3000 $14.875 S ariin Greg 08/14/98 2.000 $13.500 47,500 1$48,840.50)
Toribio, Richard 09123/97 500 $34.00 Toribio, Richard 09126/97 500 $36.00 Toribio, Richard 03123/98 100 $26.13 2000 ($17,125.00)
Walsh, Richard W. 06/29/98 850 $22.875 Walsh, Richard W. 07/02/98 100 $20.250 Walsh, Richard W. 07/08/98 350 $19.500 Walsh, Richard W. 07/10/98 9~ $21 .250 1395 $20,441 .48
Zarets , Robert 04/21/98 1000 $22.25 Zaretsky, Robert 04/21/98 1000 $22.69 Zaretsk Robert 04/23/98 1000 $22.75 Zareets , Robert 06/03/98 '1000 $16.88 4000 $27,723 .00)
Totals= 66,795 ($232,663.68) 0 0
1 DECLARATION OF SERVICE BY MAIL 2
I, the undersigned, declare : 3 1 . That declarant is and was, at all times herein mentioned, a citizen of the United States 4 and a resident of the County of San Diego, over the age of 18 years, and not a party to or interest in 5 the within action; that declarant's business address is 401 B Street, Suite 1700, San Diego, California 6 92101 . 7 2. That on May 16, 2002, declarant served the THIRD AMENDED CLASS ACTION 8 COMPLAINT FOR VIOLATION OF THE FEDERAL SECURITIES LAWS by depositing a true 9 copy thereof in a United States mailbox at San Diego, California in a sealed envelope with postage 10 thereon fully prepaid and addressed to the parties listed on the attached Service List . 11 3. That there is a regular communication by mail between the place of mailing and the 12 places so addressed . 13 I declare under penalty of perjury that the foregoing is true and correct . Executed this 16th 14 day of May, 2002, at San Diego, California. 1 5 16 17 t1WST1T4E- NAGY
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COUNSEL FOR PLAINTIFF(S )
Jan M . Adler Tor Gronborg Karen A . Batcher MILBERG WEISS BERSHAD HYNES & LERACH LL P 401 B Street, Suite 1700 San Diego, CA 92101-5050 619/231-105 8 619/231-7423 (fax )
COUNSEL FOR DEFENDANTS
Charles H . Dick, J . Shirli Fabbri Weis s Michael P . McCloskey GRAY CARY WARE & FREIDENRICH BAKER & McKENZIE LLP 101 W . Broadway, Suite 1200 4365 Executive Drive, Suite 1100 San Diego, CA 92101 San Diego, CA 92121-2133 619/236-1441 858/638-695 0 619/236-0429 (fax) 858/677-1477 (fax )
Denotes service via overnight mail . EXHIBIT C Coe 3 :03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 1 of 6 2
1 GREEN WELLING LLP ROBERT S . GREEN (136183) 2 235 Pine Street, 15th Floor San Francisco , CA 94104 3 Telephone : 415/477-6700 415/477-6710 (fax) 4 Liaison Counsel for Plaintiffs and the Clas s 5 LERACH COUGHLIN STOIA GELLER 6 RUDMAN & ROBBINS LL P SAMUEL H. RUDMAN 7 ROBERT M. ROTHMAN (Pro Hac Vice) RUSSELL J . GUNYAN 8 200 Broadhollow Road, Suite 406 Melville, NY 11747 9 Telephone: 631/367-7100 631/367-1173 (fax ) 10 Lead Counsel for Plaintiffs and the Clas s 11
12 UNITED STATES DISTRICT COURT
13 NORTHERN DISTRICT OF CALIFORNIA
14 In re PORTAL SOFTWARE, INC Master File No. C-03-5138-VRW 15 SECURITIES LITIGATION CONSOLIDATED THIRD AMENDED 16 COMPLAINT This Document Relates To : 17 JURY TRIAL DEMANDED ALL ACTIONS. 18
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28 3 :03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 2 of 6 2
1 Lead Plaintiff John Romeo ("Lead Plaintiff' or "Plaintiff') and Pipefitters Local 522 & 63 3
2 Pension Fund Trust (the "Pipefitters") allege the following based upon the investigation of their
3 counsel, which included a review of United States Securities and Exchange Commission ("SEC")
4 filings by Portal Software, Inc . ("Portal" or the "Company"), as well as regulatory filings and
5 reports, interviews with former employees of the Company, securities analysts' reports and
6 advisories about the Company, press releases and other public statements issued by the Company,
7 and media reports about the Company, and Plaintiffs believe that substantial additional evidentiary
8 support will exist for the allegations set forth herein after a reasonable opportunity for discovery .
9 NATURE OF THE ACTIO N
10 1 . This is a federal securities class action brought on behalf of purchasers of the
11 I securities of Portal between May 20, 2003 and November 13, 2003, inclusive (the "Class Period") , 12 I seeking to pursue remedies under the Securities Exchange Act of 1934 (the "Exchange Act") and the
13 Securities Act of 1933 (the "Securities Act") .
14 2. By the beginning of fiscal 2004, Portal was facing a capital crisis. The Company had
15 incurred operating losses of more than $467,000,000 during fiscal 2002-03, which wiped out more
16 than 96% of the Company's equity . If Portal continued to incur losses at the rate experienced in
17 fiscal 2003, the Company would be facing a capital deficit and would be virtually insolvent . In order
18 to address this problem, in March 2003, Portal began the process of going to the equity markets to
19 raise capital. In this regard, the Company filed a registration statement with the SEC for the sale of
20 at least $60 million of Portal common stock. Thereafter, in what amounted to a "pump" of the
21 market, Defendants began issuing numerous positive statements concerning Portal's revenue growth,
22 product and marketing initiatives, and increasing profits, including statements by defendant Little
23 that Portal would "return to [pro formal profitability and positive cash flow operations within
24 fiscal year 2004]." These statements had their intended effect as the price of Portal common stock
25 rose 45% during the Class Period reaching a peak in September 2003, when the Company sold
26 approximately $60 million worth of its common stock in a public offering (the "Secondary
27 Offering") - the "dump ."
28
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -1- CEoe 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 3 of 6 2
1 3. Unbeknownst to investors, however, Defendants' statements concerning Portal's
2 current and historical operating results were materially false and misleading for a variety of reasons .
3 Portal's seemingly increasing revenues, in truth and in fact, were the product of Defendants'
4 violations of generally accepted accounting principles ("GAAP") which had the effect of improperly
5 overstating the Company's revenues by millions of dollars during the Class Period . In addition,
6 Defendants' misrepresentations and omissions concerning the Company's true revenue recognition
7 policies and compliance with GAAP and SEC reporting requirements hid the truth from Portal's
8 public investors, rendering the financial statements included in the Company's Class Period SEC
9 filings materially false and misleading. (See ¶¶58-136.)
10 4. Specifically, when the Company sells software it may recognize license fees as
11 earned revenues when the software is delivered, in most cases . However, when the software requires
12 significant modifications, the revenue must be deferred and can only be recognized when the
13 modifications are completed. As detailed herein, Defendants violated these accounting principles
14 during the Class Period .
15 5. Moreover, in connection with certain contracts, the Company recognized revenue as
16 determined by the relationship of contract costs incurred to date as compared to the estimated tota l
17 contract costs. By artificially inflating contractual costs incurred to date, the Company recognized
18 revenue prematurely during the Class Period .
19 6. Similarly, with respect to other contracts, Portal only was able to recognize revenue
20 for partial performance when vendor specific objective evidence ("VSOE") of the value existed for
21 the contract's undelivered elements . In those situations, Portal simply fabricated the results o f
22 I analyses designed to establish vendor specific objective evidence so that revenue could b e
23 I recognized.
24 7. As a result of these improper practices, in the months immediately preceding the
25 Secondary Offering, Portal's publicly disseminated financial statements reported increasing license
26 fees compared to the prior year - a 7% increase in Q 1 2004 accelerating to a 21 % gain in Q2 2004 .
27 8. Buoyed by the Company's artificially inflated revenues and Defendants' forecast s
28 that Portal' s revenues would continue to increase for fiscal 2004 by 10-12%, the price of Portal' s
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -2- Coe 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 4 of 6 2
1 common stock increased by 45% from the beginning of the Class period, closing at $15 .05 on or
2 I about September 3, 2003 .' On September 12, 2003, the Company completed a Secondary Offerin g
3 to the public at a price of $13 .25 per share, thereby generating $60 million in net proceeds.
4 9. Unfortunately for Portal's public investors, the purported increase in the Company' s
5 revenue was a charade . On November 13, 2003 - just two months after the Company's public
6 offering - Defendants stunned the financial markets by announcing that Portal's projected financial
7 results for the third quarter fiscal 2003 had "unexpectedly" turned from a profit of $0.04 per share to
8 a loss of $0.36 to $0.40 per share. Market reaction to Defendants' shocking announcement was swift
9 and severe as the price of Portal common shares fell by more than 42% in after-hours trading,
10 opening at $8 .77 per share on November 14, 2003 .
11 10 . Defendants claimed that the operating loss was the result of "a dozen" problematic
12 sales transactions during the third quarter resulting in a revenue shortfall of about $8 million . Chief
13 among these problem sales contracts - accounting for approximately 60% of the shortfall - were six
14 contracts where Portal was "required" to defer license fees that Defendants represented would be
15 earned "up-front" when the software was delivered . Defendants also claimed that the unexpected
16 deferrals did notrepresent a change in Portal's accounting practices or revenue recognition policies .
17 However, Portal's publicly disclosed accounting policy for license fees, in fact, did change during
18 the Class Period to reflect the reality that Portal's license fees could only be recognized after
19 modifications to the software were completed . In addition, Portal's description of its revenue
20 recognition policy also changed to disclose that the Company had been accounting for fixed price,
21 service contracts during the Class Period on a "proportional performance basis ."
22 11 . Thus, in stark contrast to the purportedly positive sequential growth in license fees
23 reported by Portal during the Class Period, the Company's license fee revenues declined by more
24 than 49% during the third quarter fiscal 2004, and more than 23% during the fourth quarter fisca l
25 2004, compared to the same period in the prior year .
26
27 I' All per share prices reflect Portal's 1-for-5 reverse split effective September 29, 2003 . 28
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -3 - C fte 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 5 of 6 2
1 12 . As discussed above, Defendants were highly motivated to have Portal common share s
2 trading at as high of a price as possible in order to maximize the capital raised by the Secondary
3 Offering. Indeed, Portal's losses for all of fiscal 2004 totaled more than $40 million and would hav e
4 11 consumed the remainder of Portal's stated capital of $35 million at January 31, 2003, but for the $6 0
5 million in proceeds received as a result of the Secondary Offering . Additionally, prior to
6 Defendants' belated disclosure of Portal's true operating results and future prospects, certain of the
7 Individual Defendants, as well as other high-level executives of Portal, sold their personally-held
8 Portal common stock to the unsuspecting public reaping proceeds of more than $5 million . As
9 detailed below, each of the insider sales was unusual and suspicious in timing and amount .
10 13 . As a result of the open, well developed and efficient market for Portal stock,
11 Defendants' misrepresentations, omissions and other fraudulent conduct caused Portal's stock t o
12 trade at artificially inflated prices during the Class Period. Defendants' misrepresentations ,
13 omissions and other fraudulent conduct proximately caused damages to plaintiffs and other members
14 of the Class, as the price of Portal stock declined significantly when the truth began to be publicly
15 revealed about the Company's adverse business and financial condition that Defendants previously
16 concealed .
17 JURISDICTION AND VENUE
18 14. The claims asserted herein arise under § § 11, 12(a)(2) and 15 of the Securities Act (15
19 U.S .C. §§77k, 771 and 77o) and §§10(b) and 20(a) of the Exchange Act (15 U .S.C. §§78j(b) and
20 78t(a)) and Rule IOb-5 promulgated thereunder (17 C .F.R. §240.1Ob-5) .
21 15 . This Court has jurisdiction over the subject matter of this action pursuant to 28 U .S.C.
22 I § 1331 and §27 of the Exchange Act [15 U .S.C. §78aa] .
23 16. Venue is proper in this District pursuant to §27 of the Exchange Act, and 28 U .S.C .
24 § 1391(b) . Portal maintains its principal place of business in this District and many of the acts and
25 practices complained of herein occurred in substantial part in this District .
26 17. In connection with the acts alleged in this complaint, defendants, directly or
27 indirectly, used the means and instrumentalities of interstate commerce, including, but not limited to,
28 the mails, interstate telephone communications and the facilities of the national securities markets .
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -4- 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 6 of 6 2
1 PARTIES
2 18. Lead Plaintiff John Romeo purchased the common stock of Portal at artificiall y
3 inflated prices during the Class Period . The price of Portal's stock declined significantly when the
4 truth began to be publicly revealed about the Company's adverse business and financial condition
5 that had been concealed by Defendants' earlier misrepresentations, omissions and other fraudulent
6 conduct, and Lead Plaintiff was damaged as a result thereof. Lead Plaintiff's certification has bee n
7 previously submitted in this litigation and is hereby incorporated by reference .
8 19 . Plaintiff Pipefitters purchased Portal common stock in the Secondary Offering, as
9 defined herein, as set forth in the certification previously submitted in this litigation, which is
10 incorporated by reference herein. As a result of Defendants' misrepresentations and other conduct,
11 Pipefitters purchased Portal common stock at artificially inflated prices . The price of Portal stoc k
12 declined significantly when the truth began to be publicly revealed about the Company's adverse
13 business and financial condition that had been concealed by Defendants' earlier misrepresentations ,
14 omissions and other conduct, and Pipefitters was damaged as a proximate result .
15 20. Defendant Portal describes itself as a software provider of billing and subscribe r
16 management solutions. Portal is a Delaware Corporation with its principal executive offices located
17 at 10200 South De Anza Boulevard, Cupertino, California .
18 21 . Defendant John E. Little ("Little"), at all times relevant to this action, served as th e
19 Company's Chairman of the Board, Chief Executive Officer and Director.
20 22. Defendant Howard A. Bain, III ("Bain"), at all times relevant to this action, served as
21 the Company's Senior Vice President, Chief Financial Officer and Principal Financial Officer .
22 23 . Arthur C . Patterson ("Patterson") at all times relevant to this action, served as a
23 director of the Company .
24 24. The defendants referenced above in ¶¶21-23 are referred to herein as the "Individua l
25 Defendants."
26 25 . Because of the Individual Defendants' positions with the Company, they had acces s
27 to the adverse undisclosed information about its business, operations, products, operational trends,
28 financial statements, markets and present and future business prospects via access to internal
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -5- C~ 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 7 of 6 2
1 corporate documents (including the Company's operating plans, budgets and forecasts and reports of
2 actual operations compared thereto), conversations and connections with other corporate officers and
3 employees, attendance at management and Board of Directors meetings and committees thereof and
4 via reports and other information provided to them in connection therewith .
5 26. It is appropriate to treat the Individual Defendants as a group for pleading purpose s
6 and to presume that the false, misleading and incomplete information conveyed in the Company's
7 public filings, press releases and other publications as alleged herein are the collective actions of the
8 narrowly defined group of defendants identified above . Each of the above officers and directors of
9 Portal, by virtue of their high-level positions with the Company, directly participated in the
10 management of the Company, was directly involved in the day-to-day operations of the Company at
11 the highest levels and was privy to confidential proprietary information concerning the Company and
12 its business, operations, products, growth, financial statements, and financial condition, as alleged
13 herein. The Individual Defendants were involved in drafting, producing, reviewing and/or
14 disseminating the false and misleading statements and information alleged herein, were aware, or
15 recklessly disregarded, that the false and misleading statements were being issued regarding the
16 Company, and approved or ratified these statements, in violation of the federal securities laws .
17 27. As officers and controlling persons of a publicly-held company whose common stock
18 was, and is, registered with the SEC pursuant to the Exchange Act, and was traded on the NASDAQ,
19 and governed by the provisions of the federal securities laws, the Individual Defendants each had a
20 duty to disseminate promptly, accurate and truthful information with respect to the Company's
21 financial condition and performance, growth, operations, financial statements, business, products,
22 markets, management, earnings and present and future business prospects, and to correct any
23 previously-issued statements that had become materially misleading or untrue, so that the market
24 price of the Company's publicly-traded securities would be based upon truthful and accurate
25 information. The Individual Defendants' misrepresentations and omissions during the Class Period
26 violated these specific requirements and obligations .
27 28. The Individual Defendants participated in the drafting, preparation, and/or approval
28 of the various public and shareholder and investor reports and other communications complained o f
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -6- 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 8 of 6 2
1 herein and were aware of, or recklessly disregarded, the misstatements contained therein and
2 omissions therefrom, and were aware of their materially false and misleading nature . Because of
3 their Board membership and/or executive and managerial positions with Portal, each of the
4 Individual Defendants had access to the adverse undisclosed information about Portal's business
5 prospects and financial condition and performance as particularized herein and knew (or recklessly
6 disregarded) that these adverse facts rendered the positive representations made by or about Portal
7 and its business issued or adopted by the Company materially false and misleading .
8 29 . The Individual Defendants, because of their positions of control and authority as
9 officers and/or directors of the Company, were able to and did control the content of the various SEC
10 filings, press releases and other public statements pertaining to the Company during the Class
11 Period. Each Individual Defendant was provided with copies of the documents alleged herein to be
12 misleading prior to or shortly after their issuance and/or had the ability and/or opportunity to prevent
13 their issuance or cause them to be corrected . Accordingly, each of the Individual Defendants is
14 responsible for the accuracy of the public reports and releases detailed herein and is therefore
15 primarily liable for the representations contained therein .
16 30. Each of the defendants is liable as a participant in a fraudulent scheme and course o f
17 business that operated as a fraud or deceit on purchasers of Portal common stock by disseminating
18 materially false and misleading statements and/or concealing material adverse facts . The scheme : (i)
19 deceived the investing public regarding Portal's business, operations, management and the intrinsic
20 value of Portal common stock; (ii) enabled the Company to complete a $60 million public offering
21 of its common stock ; (iii) allowed Portal insiders, including certain of the Individual Defendants to
22 sell 368,126 shares of their personally-held Portal shares at artificially inflated prices generating
23 illicit proceeds of more than $5 million ; (iv) induced plaintiffs and other members of the Class to
24 purchase Portal securities at artificially inflated prices ; and (v) proximately caused damages to the
25 plaintiffs and the other members of the Class when the price of Portal's stock declined after
26 Defendants began publicly to reveal to investors and the market the truth concerning the Company's
27 adverse business and financial condition that had been concealed by Defendants' prior
28 misrepresentations, omissions and other fraudulent conduct .
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -7- 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 9 of 6 2
1 II Undisclosed Adverse Information
2 31 . The market for Portal's securities was open, well-developed and efficient at al l
3 relevant times . As a result of these materially false and misleading statements and failures to
4 disclose, Portal's common stock traded at artificially inflated prices during the Class Period .
5 Plaintiff and other members of the Class purchased or otherwise acquired Portal securities relying
6 upon the integrity of the market price of Portal's securities and market information relating to Portal,
7 and have been damaged thereby .
8 32. During the Class Period, Defendants materially misled the investing public, thereb y
9 inflating the price of Portal's securities, by publicly issuing false and misleading statements and
10 omitting to disclose material facts necessary to make defendants' statements, as set forth herein, not
11 false and misleading . Said statements and omissions were materially false and misleading in that
12 they failed to disclose material adverse information and misrepresented the truth about the Company,
13 its business and operations .
14 33. At all relevant times, the material misrepresentations and omissions pa rticularized in
15 this Complaint directly or proximately caused or were a substantial contributing cause of the
16 damages sustained by plaintiffs and other members of the Class . As described herein, during the
17 Class Period, Defendants made or caused to be made a series of materially false or misleading
18 statements about Portal's business, prospects and operations . These material misstatements and
19 omissions had the cause and effect of creating in the market an unrealistically positive assessment of
20 Portal and its business, prospects and operations, thus causing the Company's securities to be
21 overvalued and artificially inflated at all relevant times . Defendants' materially false and misleading
22 statements during the Class Period resulted in plaintiffs and other members of the Class purchasing
23 the Company's securities at artificially inflated prices . Defendants' fraudulent conduct caused the
24 damages complained of herein in that the Defendants' misrepresentations and other conduct
25 artificially inflated Portal's stock price, which stock price subsequently declined 42% when the truth
26 began to be publicly revealed about the Company's adverse business and financial condition that had
27 been concealed by Defendants' earlier misrepresentations, omissions and other fraudulent conduct,
28 and Lead Plaintiff was damaged as a proximate result .
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -8- Cadle 3 :03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 10 of 62
1 PLAINTIFFS ' CLASS ACTION ALLEGATION S
2 34. Plaintiffs bring this action as a class action pursuant to Federal Rule of Civil
3 Procedure 23(a) and (b)(3) on behalf of a Class, consisting of all those who purchased or otherwise
4 acquired the securities of Portal during the Class Period and who were damaged thereby . Excluded
5 from the Class are defendants , the officers and directors of the Company , at all relevant times,
6 members of their immediate families and their legal representatives , heirs, successors or assigns and
7 any entity in which defendants have or had a controlling interest .
8 35 . The members of the Class are so numerous that joinder of all members is
9 impracticable . Throughout the Class Period , Portal common shares were actively traded on the
10 NASDAQ . While the exact number of Class members is unknown to plaintiffs at this time and can
11 only be ascertained through appropriate discovery ; plaintiffs believe that there are hundreds or
12 thousands of members in the proposed Class . Record owners and other members of the Class may
13 be identified from records maintained by Portal or its transfer agent and may be notified of the
14 pendency of this action by mail, using the form of notice similar to that customarily used in
15 securities class actions .
16 36. Plaintiffs ' claims are typical of the claims of the members of the Class as all members
17 of the Class are similarly affected by defendants ' wrongful conduct in violation of federal law that is
18 complained of herein .
19 37. Plaintiffs will fairly and adequately protect the interests of the members of the Class
20 and have retained counsel competent and experienced in class and securities litigation .
21 38. Common questions of law and fact exist as to all members of the Class and
22 predominate over any questions solely affecting individual members of the Class . Among the
23 questions of law and fact common to the Class are :
24 (a) whether the federal securities laws were violated by defendants' acts a s
25 alleged herein ;
26 (b) whether statements made by defendants to the investing public during the
27 Class Period misrepresented material facts about the business, operations and management of Portal ;
28 and
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -9- Cal le 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 11 of 6 2
1 (c) to what extent the members of the Class have sustained damages and th e
2 proper measure of damages .
3 39. A class action is superior to all other available methods for the fair and efficien t
4 adjudication of this controversy since joinder of all members is impracticable . Furthermore, as the
5 damages suffered by individual Class members may be relatively small, the expense and burden of
6 individual litigation make it impossible for members of the Class to individually redress the wrong s
7 done to them. There will be no difficulty in the management of this action as a class action .
8 SUBSTANTIVE ALLEGATION S
9 Background Facts
10 40 . Portal describes itself as a provider of software billing and customer management
11 solutions. According to the Company's SEC filings, since at least 1997, Portal has derived all of its
12 revenues from one product line - Infranet. Substantially all of Portal's "license fees" are derived
13 from the licensing of its Infranet product line . The Company's "service fees" are primarily
14 comprised of system implementation fees, consulting fees, maintenance agreements and training .
15 Defendants' Improper Revenue Recognition Practice s
16 41 . Following the "dot .com" crash of 2001, Portal's customer base suffered significant
17 deterioration . One former Portal employee recounted that approximately 75% of Portal's customer
18 base at the time of the crash consisted of dot.com start-ups that ceased doing business with th e
19 Company shortly thereafter . As described above, Portal incurred devastating financial losses during
20 fiscal 2002-03 that wiped out over 96% of the Company's equity as it struggled to obtain a new
21 customer base for its products . As a result, since at least fiscal 2003, Portal increased its marketing
22 focus on larger more sophisticated customers including emerging telecommunications providers .
23 The business requirements of these larger telecommunications customers, however, often required
24 Portal to make significant "rewrites" and customization of the software prior to implementation .
25 According to a former Portal controller, the need to modify Portal's software wreaked havoc with
26 the Company's license fee revenue recognition practices . The former Portal accounting controller,
27 employed from April 1997 through June of 2002, informed Lead Plaintiff that :
28
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Portal was struggling to find new customers, and many of the large customers that it was trying to develop, insisted on certain features 2 [in] the software . In an attempt to procure these deals, [Portal] worked with the customer company, trying to rewrite the software, and customize it in a manner most beneficial to the customer . This created problems for Portal because it was incurring costs while it 4 was customizing the software . It is against GAAP to recognize revenue on a license of software, and then later change the software . [Defendants] knew that if they changed the software in the middle of the implementation, it would make the revenue unrecognizable . 6 [Defendants were] very conscious of this during [fiscal 2003] .
42. The former controller further stated that in order to ensure that license fees could be
recognized `up-front' during fiscal 2004, Defendants manipulated Portal's license agreements with
9 its customers . According to the former controller, prior to fiscal 2004 it had been Portal's practice to
10 sell "developmental" licenses to its customers as a trial version for a nominal price prior to full-scale
11 licensing throughout the customer's organization . The former controller described to Lead Plaintiff
12 the licensing process as it existed prior to fiscal 2004 :
13 Portal would first put a so-called developmental license in place when doing business with a customer . Such a developmental license was 14 available for customers that wanted to try the software before committing to purchasing it . This license would be typically sold for 15 a nominal amount to a customer company, so that the company could try out the product and see if it would work for their needs . The 16 developmental license would usually only be licensed to one or two users and would cost [the customer] around $50,000 . If the customer 17 was happy with its capabilities, then the customer company would license the entire software package at which time additional revenue 18 could then be recognized.
19 43. During fiscal 2004, however, the former controller stated that Portal structured many
20 of its license agreements in two parts - a "developmental" license and a "production" license .
21 According to the former controller, the production license would typically include significant
22 modifications to Portal's software . However, the witness was advised by several Company insiders
23 employed during the Class Period that rather than "price" the production license accordingly - with a
24 bulk of the license fee - defendants "priced" the developmental license - which remained merely a
25 trial version of the product - at a much higher price than historically had been the case . According
26 to the former controller this allowed Portal - on paper at least - to report much higher up-fron t
27 license fees. The former controller was advised by these corporate insiders that : 28
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[During fiscal 2004] Portal split the way it recognized revenue on the licensing of its software . This split was intended to help Portal 2 recognize revenue upfront on these more complex and time- consuming deals . Portal began to recognize a developmental license and a production license, at the same time.
4 Portal was recognizing large amounts for the developmental software, and then reconfiguring the software for the customer . Portal was recognizing the bulk of the revenues upfront, and using the production license as the more nominal of the two types of license agreements. This creates a problem with revenue recognition because a company is not supposed to recognize revenue on software until the 7 program is completely written . [Portal] can implement software in a fashion necessary for its successful operation, but [Portal could not] rewrite the program . Ernst and Young changed its position on Portal's determination, and shortly thereafter, the shortfall in earnings 9 came, and the stock price dropped.
10 Portal was recognizing revenue even though features that the [customer] desired had not been delivered. [Furthermore] many of 11 the contracts were so convoluted that the present and future promises could not be separated . In such a case, [Portal] should not recognize 12 any revenue, whereas, [defendants were] recognizing all or most [the] revenue. [Emphasis added .] 13 44. In addition, a former Senior Business Analyst, employed by the Company from Ma y 14 2001 through July 2003, admitted that the Company's revenue numbers were "cooked" at the 15 specific direction of Defendant Bain . Indeed, the witness stated that accounting personnel were fired 16 if they did not come up with the results demanded by management, regardless of whether those 17 purported results had any basis in reality . 18 45. For example, depending on how much revenue the Company felt it needed t o 19 recognize, management would tell this Senior Business Analyst what the results of his revenu e 20 recognition study should be and required him to "reverse engineer" an analysis to reach that result . 21 As the witness admitted to Lead Plaintiff: 22 If that analysis was ever held up to any scrutiny by the auditors, I 23 don't think there is any way it could have passed because, basically, I reversed engineered it through some very selective querying of the 24 database.
25 46. This witness further stated that he would be required to falsify billing rates o f
26 individuals working on projects so that the Company could prematurely recognize the associate d
27 revenue. For example, in connection with contracts performed in foreign countries, Bain and other
28 11 members of management would tell the Senior Business Analyst that they needed him to perform a n
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1 analysis that resulted in the hourly billing rate of the Company's associates being higher than their
2 actual rates. The witness then would "selectively query" the database by excluding unfavorable data
3 and come up with a result that matched management's demand . The Company would take this
4 contrived billing rate and apply it to the work performed at the outset of the contract so that, under
5 the Company's revenue recognition policy, the Company could recognize service revenue
6 prematurely.
7 47. Pursuant to GAAP, when a software arrangement involved multiple elements (i.e. ,
8 licensing and services) the revenue from the entire arrangement must be allocated to each element of
9 the arrangement based on its "fair value ." The portion of the revenue allocated to each element
10 should generally be recognized when : (1) persuasive evidence of the element exists ; (2) delivery of
11 the element has occurred; (3) the element's fee is fixed and determinable ; and (4) the collectibility of
12 the element is probable. However, GAAP provides that if evidence of the "fair value" of each of the
13 elements does not exist, allrevenue from the arrangement must be deferred until the earlier of when
14 (1) such evidence does exist ; (2) all elements have been delivered; or (3) the evidence of fair market
15 value exists for the undelivered elements . Accordingly, in connection with certain contracts, GAAP
16 did not permit Portal to recognize any revenue for partial performance unless the Company
17 possessed VSOE of the value of the contracts undelivered elements . In those situations,
1 8 management, including Defendant Bain, required the Senior Business Analyst to fabricate studies so
19 that the Company could claim that VSOE existed . With respect to VSOE analysis, the witness
20 advised Lead Plaintiff that :
21 Basically, the numbers were almost cooked essentially to come out to be what the management team wanted them to be, and by the 22 management team, I am talking about the CFO Howard Bain and the Senior Director of Revenue Accounting Charlotte Weisel . They 23 would tell me what the results of the analysis should be before I even started it. 24 48. During the Class Period, the Senior Business Analyst was required to perfor m 25 analyses that matched management's predetermined results for work performed in countries such as 26 Greece, Italy, Columbia and Spain in connection with at least six of Portal's major contracts, 27
28
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1 including its contract with Columbia Mobile . The witness advised Lead Plaintiff that the Company
2 was able to book $5 million in revenue as a result of these contracts .
3 49. Another former employee of the Company, an accounts receivable and revenu e
4 assurance assistant employed by Portal during the Class Period, confirmed that Defendants routinely
5 manipulated Portal's fee recognition practices during the Class Period in order to inflate the
6 Company's current revenues . In particular, the former employee stated that revenues related to
7 contracts with Onstar, a subsidiary of General Motors, had been materially overstated during the
8 third quarter of fiscal 2004 . The former employee informed Lead Plaintiff that :
9 Portal frequently recognized revenue incorrectly . Most of Portal's software licensing contracts included support, maintenance, and 10 upgrade elements. Portal booked all of the revenue associated with these different elements up front . Even though all of this revenue had 11 already been recognized up front, in fact, this revenue should have been deferred over a period of time . One of my duties was to 12 reclassify the revenue for future quarters . For three months I worked nearly nonstop, and could never get ahead, because Portal continued 13 to book revenue incorrectly . I kept on changing it, and changing it.
14 I told my manager on a few occasions early on in her employment that she did not agree with the way Portal was carving out its revenue. 15 [My] manager told me to complete the work and limit my questions about it. I have been working with revenue recognition for 12 years, 16 and I understand the way revenue is supposed to be recognized . I was fired because I was raising red flags as to how Portal was 17 recognizing revenue . But when I raised concerns about the Company's revenue recognition practices . I was told to book the 18 revenue as instructed. Ultimately, my objections and concerns had made me "a burden" to the company [ . . .] I received my layoff notice 19 in a very cold manner.
20 50. Additionally, Defendants routinely recognized license and services fees under certai n
21 of Portal's service arrangements prior to customer approval of specific project milestones in
22 violation of the Company's publicly stated revenue recognition practices and policies . Such
23 improper recognition of revenues artificially inflated the Company's reported and projected revenues
24 during the Class Period and violated GAAP because revenue was recognized before collectibility
25 was reasonably assured. In fact, subsequent to the Class Period Defendants admitted that at least
26 $700,000 of Portal's fiscal 2004 revenues were improperly recognized prior to approval of specific
27 project milestones by Portal's customers .
28
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1 Defendants Failed to Disclose that Deman d for Portal 's Products Was in Material Decline 2 51 . During the Class Period, Defendants failed to disclose that the Company's sales and 3 marketing efforts were not performing well and the Company was experiencing declining demand 4 for its products and services . In particular, according to a former employee of the Company, Portal's 5 customer service applications, which prior to the Class Period had been licensed as a part of Portal's 6 billing software, were no longer required by many of Portal's large telecommunications customers . 7 The former Portal Senior Marketing Manager, employed through June 2003, informed Lead Plaintiff 8 that: 9 [T]elecommunications software billing is a very niche market and 10 Portal did not have an abundance of competitors, although it did have some. However, the telecommunications billing market has actuall y 11 been shrinking for some time. Not only has the widely-publicized downturn in the telecommunications industry diminished the market 12 for billing software, but software billing applications themselves do less in a customer's software infrastructure than they used to. For 13 instance, in the past, billing applications like the kind sold by Portal would perform "backend" accounting functions related to a 14 company's Accounts Receivable, customer care, collections and also taxation. However, new Customer Relationship Management 15 ("CRM") applications from other software vendors have replaced the customer-care function previously provided by billing applications ; 16 similarly, accounting functions previously handled by billing applications are now handled by non-billing software applications . 17 Specifically Siebel and SAP [are] two software vendors (although 18 there are others) that have displaced the role previously provided by billing applications for CRM and Accounts Receivables, respectively. 19 It is these applications from other vendors with which Portal's software must be able to interface effectively (via an API). 20 52 . Given the market dynamics of a shrinking market and role for billing software 21 applications, the former Senior Marketing Manager stated that Portal's overall opportunities for 22 growth did not have "huge upside potential ." 23 53. As a result, Defendants' were on notice that demand for Portal's software applications 24 had materially declined and was unlikely to rebound . Furthermore, Defendants' public statements 25 and SEC filings materially misrepresented the role that Portal's software applications were required 26 to perform within a customer's software infrastructure . 27
28
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1 54. In addition, due to continuing and severe problems with the Company's core
2 products, the Company was unable to service its existing customers, causing additional erosion of
3 the Company's revenue streams. According to the former Senior Marketing Manager, Portal's
4 software had many problems or deficiencies that made meeting implementation/customization
5 milestones difficult . These product deficiencies included, but are not limited to, excessive bugs
6 and/or interface problems with other applications . As a result, Portal was spending too much money
7 on fixing bugs and improving application interfaces causing the Company's costs to rise . The
8 strategy of targeting increasingly larger customers, led the Company to experience more severe
9 problems as Portal's software was "more prone to bugs" as a result of the increased scope of these
10 projects.
11 Defendants Engaged in Significant Insider Sellin g Prior to the Disclosure of the Truth About the Company and Its Busines s 12 55 . During the Class Period, the Individual Defendants and other high-level executives of 13 Portal collectively sold $5 million worth of their personally-held Portal common stock to the 14 unsuspecting public . 15 56. Defendants' insider sales were unusual and suspicious in timing and amount for th e 16 following reasons among others : 17 (a) as set forth in the chart below, the Individual Defendants and other Portal 18 insiders sold in a range of 1% to 96% of the Portal shares they directly owned during the Class 19 Period; 20 (b) no shares of Portal common stock were sold by any of these individuals in th e 21 twelve months preceding the Class Period; and 22 (c) in each instance, the timing of the insider sales shortly followed a bullish 23 announcement by defendants concerning the Company's current financial results and/or future 24 earnings prospects . 25 57 . The following table details the sales by the Individual Defendants and other high- 26 level Portal insiders which totaled more than $5 million during the Class Period : 27
28
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1 Insider Date of Price Pe r Shares Proceeds % of Sale Share Sold Holdings 2 Marc Aronson, Senior VP 06/06/03 $10.0000 4,000 $40,000 .00 57.66% 06/06/03 $9.5000 6,000 $57,000 .00 37.35 % 3 06/06/03 $9 .5000 8,254 $78,414 .90 39.75 % 06/18/03 $9 .7500 60 $585 .00 0.99 % 4 06/18/03 $9.5000 79 $750 .50 1.30 % 06/20/03 $9.7500 3,800 $37,050 .00 63 .31 % 5 22,193 $213,800.4 0 6 Howard A. Bain, III, CFO 07/01/03 $9.0500 1,100 $9,955 .00 18.20% 7 07/02/03 $9.1000 840 $7,644.00 29.14 % 07/02/03 $9.0500 2,060 $18,643 .00 41.68 % 8 4,000 $36,242.0 0
9 Mitchell L. Gaynor, Secretary 06/02/03 $9.0750 382 $3,463.02 15 .09% 06/24/03 $9.9500 5,000 $49,750 .00 69.96 % 10 5,382 $53,213 .02
11 David Labuda, Chief Technical Officer 06/06/03 $9 .5750 10,000 $95,750 .00 0.52% 06/12/03 $8 .6405 10,220 $88,305 .91 0.54% 12 06/13/03 $8.7500 9,780 $85,575 .00 0.52% 06/18/03 $9.5000 10,000 $95,000 .00 0.53 % 13 06/20/03 $9.5690 10,000 $95,690 .00 0.54% 06/24/03 $9.9075 20,000 $198,150.00 1 .08 14 % 70,000 $658,470.9 1 15 Arthur C . Patterson, Director 09/23/03 $16.2710 98,892 $1,609,071 .73 14 .52% 16 09/23/03 $16.2710 5,892 $95,868 .73 14 .51 % 09/23/03 $16.2710 1,968 $32,021 .33 14 .55 % 17 09/23/03 $16.2710 13,248 $215,558.21 14 .51 % 09/24/03 $15.9250 8,832 $140,649.60 11 .31 % 18 09/24/03 $15.9250 65,928 $1,049,903 .40 11 .32 % 09/24/03 $15.9250 3,928 $62,553 .40 11 .35 % 19 09/24/03 $15 .9250 1,312 $20,893 .60 11 .31 % 200,000 $3,226,520.0 0 20 Michael A. Vescuso, Senior VP 21 05/28/03 $10 .1000 6,000 $60,600 .00 90.33% 06/06/03 $10.0000 1,802 $18,020.00 73 .72 % 22 7,802 $78,620.0 0
23 Glenn R . Weinkoop, COO 08/22/03 $13.2485 9,569 $126,777 .55 87 .24% 08/22/03 $13.2485 40,117 $531,490.07 86 .62 % 24 08/22/03 $13.2485 9,063 $120,068.51 96.63 % 58,749 $778,336.1 3 25 Grand Total 368,126 $5,045,202.46 13.88%
26
27
28 1
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1 Materially False and Misleading Statements Issued During the Class Perio d 2 58. The Class Period begins on May 20, 2003, when Portal announced its financial result s 3 for first quarter fiscal 2004, the three months ended May 2, 2003. Under the banner headline, "Third 4 Consecutive Quarter of Revenue and Business Growth," Defendants reported that Portal's revenues 5 for the quarter totaled $32.1 million, compared to revenues of $31 .1 million in the prior quarter . 6 Defendants also reported that excluding amortization of acquisition-related costs, Portal's net loss 7 was $2.0 million, or $0 .01 per diluted share compared to a net profit of $0 .5 million, or $0 .00 per 8 share in the same period last year . The press release provided, in pertinent part : 9 "Our product business model is working, and we are executing 10 effectively delivering product-based solutions," said John Little, chief executive officer at Portal Software . " We are the only company in 11 our market reporting increasing revenues and quarter-to-quarter product license growth ." [Emphasis added.] 12 Defendants also stated that the Company's revenues were expected to grow by 10-12% over th e 13 prior year and that the Company would "return to pro forma profitability [excluding certai n 14 I acquisition costs] and positive cash flow operations within the current fiscal year ." 15 59 . On or about June 3, 2003 , an article published by AFX News Limited reported that 16 Portal announced the formation of a strategic alliance with Microsoft . According to the report the 17 companies plan to develop a telecommunications billing platform, combining Portal's billing and 18 subscriber management software with Microsoft's NET technologies . Portal common shares rose 19 more than 20% on news of the Microsoft alliance . 20 60. On or about June 16, 2003, Portal filed its quarterly report Form 10-Q with the SEC , 21 for the three months ended May 2, 2003 (the "Q1 2004 10-Q") . The report, signed by defendant 22 Bain, included the Company's previously announced financial results and acknowledged that 23 "Portal's revenue recognition policy is significant because revenue is a key component of its results 24 of operations ." 25 61 . In that regard, the Q 12004 10-Q included the following representation concerning th e 26 Company's revenue recognition policies : 27 Revenue from license fees is recognized when persuasive evidence of an 28 arrangement exists, delivery of the product has occurred, the fee is fixed o r
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determinable and collectibility is probable . Pursuant to the requirements of Statement of Position ("SOP") 97-2 "Software Revenue Recognition" and 2 SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions," Portal uses the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date and vendor specific objective evidence of the 4 fair value ("VSOE") of all undelivered elements exists . VSOE for undelivered elements is based on normal pricing for those elements when sold separately and, for maintenance services, is additionally measured by the renewal rate . The software is considered to have been delivered when Portal 6 has provided the customer with the access codes that allow for immediate possession of the software .
62. The Ql 2004 10-Q further represented that Portal's services revenues were
recognized as the services were performed, subject to project milestone acceptance by the customer : 9 When licenses arrangements include services, the license fees are 10 recognized upon delivery, provided that (1) the criteria set forth in the above paragraph have been met, (2) payment of the license fees is not 11 dependent upon the performance of the services, and (3) the services are not essential to the functionality of the software . When software 12 services are not considered essential, which has been the case in the majority of the Company's license arrangements, the revenue related 13 to the time and materials services is recognized as the services are performed. Portal recognizes consulting revenue as services are 14 performed. If a services agreement includes milestones, Portal does not recognize revenue until customer acceptance has occurred. 15 63. Regarding the Company's sales agreements that include both licensing and service s 16 components, the Q 1 2004 10-Q represented that Portal recognizes licensing revenues by using the 17 percentage-of-completion accounting method . The Form 10-Q stated in pertinent part as follows : 18 For arrangements that do not meet the above criteria, both the license 19 revenues and services revenues are recognized under the percentage- of-completion contract method in accordance with the provisions of 20 SOP 81-1, "Accounting for Performance of Construction Type and Certain Production Type Contracts ." Portal follows the percentage- 21 of-completion method since reasonably dependable estimates of progress toward completion of a contract can be made . The 22 Company estimates the percentage-of-completion on contracts utilizing hours incurred to date as a percentage of the total estimated 23 hours at project completion. Recognized revenues and profit are subject to revisions as the contract progresses to completion . 24 Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known . 25 64. The statements referenced above in ¶¶58-63, above, were each materially false an d 26 misleading when made as they misrepresented and/or omitted the following adverse facts which the n 27
28
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1 11 existed and disclosure of which was necessary to make the statements made not false and/o r 2 11 misleading, including:
3 (a) that the Company's license revenues were materially overstated due to .
4 Defendants' artificial manipulation of Portal's licensing arrangements . Specifically, the Company's
5 structuring of licenses in two parts - developmental and production - allowed Defendants to
6 improperly accelerate the recognition of license fees during the Class Period. Thus, Defendants'
7 representations that the Company recognized its licensing revenue upon delivery or using the
8 percentage of completion accounting method (i.e., prior to completion of the project) were materially
9 false and misleading when made . In fact, Portal's reported and projected revenues during the Class
10 Period were materially overstated by millions of dollars due to Defendants' knowing or reckless
11 acceleration of purported license revenues in violation of GAAP and Portal's contractual obligations .
12 In particular, Plaintiff's investigation revealed that revenues under Portal's sales arrangements with
13 Onstar, a subsidiary of General Motors, were routinely accelerated, in violation of Portal's
14 contractual obligations, during fiscal 2004 . Furthermore, Defendants' premature recognition of
15 Portal licensing revenue violated GAAP because the revenue was recognized prior to delivery of the
16 modified software to Portal's customers . As a result, Portal's Class Period financial statements were
17 materially false and misleading;
18 (b) that the Company's revenues were further overstated due to the Defendants '
19 deliberate manipulation of the purported billable rates of Portal's employees . Specifically, in
20 connection with contracts performed in foreign countries, Defendants applied fraudulently inflated
21 billing rates that improperly permitted Defendants to front load purported contractual costs and
22 thereby prematurely recognize revenue ;
23 (c) that with respect to transactions that included one or more elements to b e
24 delivered at a future date, Portal recognized revenue even though Portal deliberately manipulated
25 the necessary vendor specific objective evidence of the fair value of all undelivered elements ;
26 (d) that Defendants routinely recognized license and services fees under servic e
27 arrangements prior to customer approval of specific project milestones in violation of the Company' s
28 publicly stated revenue recognition practices and policies . Such improper recognition of revenue s
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1 artificially inflated the Company's reported and projected revenues during the Class Period and
2 violated GAAP because the revenue was recognized before collectibility was reasonably assured. In
3 fact, subsequent to the Class Period, Defendants admitted that at least $700,000 of Portal's fiscal
4 2004 revenues were improperly recognized prior to approval of specific project milestones by
5 Portal's customers ;
6 (e) that the Company's sales and marketing efforts were not performing well and
7 the Company was experiencing declining demand for its products and services ;
8 (f) that the Company's sales and marketing efforts were not performing well and
9 the Company was experiencing declining demand for its products and services . In particular,
10 according to a former employee of the Company, Portal's customer service applications which prior
11 to the Class Period had been licensed as a part of Portal's billing software were no longer required
12 by many of Portal's large telecommunications customers . As a result, demand for these applications
13 had materially declined and was unlikely to rebound . Defendants' statements materially
14 misrepresented the role that Portal's software applications were required to perform within a
15 customer's software infrastructure . For example, prior to the Class Period, billing applications like
16 the kind sold by Portal would perform "backend" accounting functions related to a company's
17 accounts receivable, customer care, collections and also taxation . However, new customer
18 relationship management ("CRM") applications from other software vendors have replaced the
19 customer-care function previously provided by Portal's billing applications . Similarly, accounting
20 functions previously handled by Portal's billing applications are now handled by non-billing
21 software applications . Specifically, Siebel and SAP are two software vendors, among others, that
22 have displaced the role previously provided by Portal's billing applications for customer service and
23 accounts receivables, respectively ;
24 (g) that due to continuing and severe problems with the Company's core products ,
25 the Company was unable to service its existing customers, causing additional erosion of the
26 Company's revenue streams . According to a former Portal employee, Portal's software had many
27 problems or deficiencies that made meeting implementation/customization milestones difficult
28 including excessive bugs and/or interface problems with other applications. As a result, Portal wa s
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1 spending too much money on fixing bugs and improving application interfaces causing the
2 Company's costs to rise . The strategy of targeting increasingly larger customers, led the Company
3 to experience more severe problems as Portal's software was "more prone to bugs" as a result of the
4 increased scope of these projects ; and
5 (h) as a result of the foregoing, Defendants' statements, opinions and projection s
6 I concerning Portal's historical and projected revenues, earnings, financial condition and current an d
7 future business prospects were lacking in a reasonable basis at all times .
8 65. Immediately after the announcement of the Microsoft alliance and the Company' s
9 highly positive first quarter earnings announcement, Portal insiders collectively sold 89,157 shares
10 of Portal common stock at artificially inflated prices reaping proceeds of more than $1 million as
1 1 follows : (i) between May 28, 2003 and June 6, 2003, Michael A . Vescuso, a senior vice president of
12 the Company, sold 7,802 shares of Portal common stock at prices ranging from $10 .00 to $10.10 per
13 share, generating proceeds of more than $78,000 ; (ii) between June 2, 2003 and June 24, 2003,
14 Mitchell A. Gaynor, the Company's secretary, sold 5,382 shares of Portal common stock at prices
15 ranging from $9 .075 to $9 .95 generating proceeds of more than $53,000 ; (iii) between June 6, 2003
16 and June 24, 2003, David Labuda sold 70,000 shares of Portal common stock at prices ranging from
17 $8.6405 to $9 .9075 per share, generating proceeds of more than $658,000 ; (iv) between June 6, 2003
18 and June 20, 2003, Marc Aronson sold 22,193 shares of Portal common stock at prices from $9 .50 to
19 $10.00 per share, generating proceeds of more than $213,800 ; and (v) on July 1, 2003 and again on
20 July 2, 2003, defendant Bain sold 4,000 shares of Portal common stock at prices ranging from $9 .05
21 to $9.10 per share, generating proceeds of more than $36,000 .
22 66. On or about August 19, 2003, Portal announced its second quarter fiscal 200 4
23 financial results, for the period ended August 1, 2003 . Under the banner headline, "Fourth
24 Consecutive Quarter of Revenue and Business Growth," defendants reported that the Company's
25 revenues for the quarter totaled $33 .2 million, compared to revenues of $32.1 million in the prior
26 quarter, and $28.8 million for the same period last year . Defendants also reported that Portal's net
27 loss for the second quarter fiscal 2004 was $2 .5 million, or $0 .01 per share compared to $11 . 1
28 11 million, or $0.06 per share in the second quarter of fiscal 2003 .
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67. On or about September 12, 2003, Portal filed its quarterly report Form 10-Q with th e
2 SEC, for the three months ended August 1, 2003 (the "Q2 2004 10-Q") . The report, signed by
defendant Bain, incorporated the Company's previously announced financial results and again
4 acknowledged that "Portal's revenue recognition policy is significant because revenue is a key
component of its results of operations" .
68. In that regard, the Q2 2004 10-Q included the following representation concerning th e
Company's revenue recognition policies:
Revenue from license fees is recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is 9 fixed or determinable and collectibility is probable . Pursuant to the requirements of Statement of Position ("SOP") 97-2 "Software 10 Revenue Recognition" and SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain 11 Transactions," Portal uses the residual method to recognize revenue when a license agreement includes one or more elements to be 12 delivered at a future date and vendor specific objective evidence of the fair value ("VSOE") of all undelivered elements exists . VSOE 13 for undelivered elements is based on normal pricing for those elements when sold separately and, for maintenance services, is 14 additionally measured by the renewal rate . The software is considered to have been delivered when Portal has provided the 15 customer with the access codes that allow for immediate possession of the software. 16 69 . The Q2 200410- Q further represented that Po rtal' s service revenues were recognized 17 is the services were performed, subject to project milestone acceptance by the customer : 18 When licenses arrangements include services, the license fees are 19 recognized upon delivery, provided that (1) the criteria set forth in the above paragraph have been met, (2) payment of the license fees is not 20 dependent upon the performance of the services, and (3) the services are not essential to the functionality of the software . When software 21 services are not considered essential, which has been the case in the majority of the Company's license arrangements, the revenue related 22 to the time and materials services is recognized as the services are performed. Portal recognizes consulting revenue as services are 23 performed. If a services agreement includes milestones, Portal does not recognize revenue until customer acceptance of the milestone has 24 occurred.
25 70. Regarding the Company' s sales agreements that include both licensing and service s
26 ;omponents, the Q2 2004 10-Q represented that Po rtal recognizes licensing revenues using th e
27 )ercentage-of-completion method. However, the description of Portal's "percentage-of-completion"
28 nethod differed from that set forth in Q 1 2004 10-Q in that now Portal's revenue recognition wa s
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subject to "meeting agreed milestones" which needed to be "accepted by the customer." In
2 11 particular, the Q2 2004 10-Q stated, in pertinent part, as follows :
For arrangements that do not meet the above criteria, both the license revenues and services revenues are recognized under the percentage- 4 of-completion contract method in accordance with the provisions of SOP 81-1, "Accounting for Performance of Construction Type and Certain Production Type Contracts ." Portal follows the percentage- of-completion method where reasonably dependable estimates of progress toward completion of a contract can be made . The Company estimates the percentage-of-completion on contracts 7 utilizing hours incurred to date as a percentage of the total estimated hours at project completion, subject to meeting agreed milestones. In the event that a milestone has not been reached, the associated cost is deferred and revenue is not recognized until the milestone 9 has been accepted by the customer. Recognized revenues and profit are subject to revisions as the contract progresses to completion. 10 Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. 11 71 . The statements in ¶¶66-70, each caused the price of Portal stock to rise . 12 72 . The statements referenced above in ¶¶66-70 above, were each materially false an d 13 misleading when made for the reasons stated in ¶64, above . 14 THE TRUTH BEGINS TO EMERGE 15 73 . On November 13, 2003, after the close of the market, Defendants announced that 16 Portal expected net losses of $0 .36 - 0.40 per share for the third quarter fiscal 2004 versus prior 17 earnings guidance of net profits of $0 .04 per share. Defendants cited contract delays and revenue 18 recognition deferrals . The press release stated, in relevant part, the following : 19 Revenue for the third quarter is now expected to be in the range of 20 $25 million to $26 million. Both license and services revenue declined on a sequential basis . The Company expects to report a pro 21 forma loss in the range of $0.27 to $0.31 per share for the quarter and a loss on a GAAP basis in the range of $0 .36 to $0.40 per share for 22 the quarter . Pro forma amounts in the third quarter of fiscal year 2004 exclude amortization of acquisition-related costs of $0 .7 million 23 and a stock option compensation charge of $3 .0 million.
24 "As we continue our evolution from a product to a solutions company, we are working with larger companies on longer-term 25 projects requiring more complex, end-to-end solutions and increasing demands on our solutions delivery capabilities," said John Little, 26 Portal's founder and CEO. "As a result, two factors primarily contributed to revenues and earnings coming in below expectations: 27 timing and services execution . The majority of our shortfall is due to contract delays and revenue recognition deferrals, particularly with 28 our existing Tier 1 customers . We also experienced some services
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execution issues that have resulted in a shortfall in services revenues and higher costs that, along with the higher mix toward services is 2 expected to reduce gross margins to around 50% . Nevertheless, we remain confident that we understand the steps needed to improve our 3 execution, that our strategy is the right one, and that we are well- positioned for the future ." 4 74. During a conference call with analysts held later that day, defendant Bain purporte d 5 to describe the major reasons for Portal's $8 million revenue shortfall and expected earnings miss . A 6 transcript of the call published on Fair Disclosure Wire stated in pertinent part as follows : 7 The first, approximately $2 million of the shortfall, is attributable to 8 transactions with two customers that did not close during the quarter as anticipated, and are now expected to close during the fourth 9 quarter. In each of these cases, one with an existing customer, an SI is involved in finalizing the contract terms and conditions . The 10 second timing issue, approximately $5 million, is all supported by signed license agreements, a majority of which were received during 11 the last two weeks of the quarter. This is the proverbial hockey stick that we see in enterprise software companies . These contracts 12 represent revenue which will be recognized over periods longer than originally anticipated, as the negotiated terms of the final contracts 13 signed with the customers differed from initial forecast expectations, largely due to the license being tied to some kind of service or future 14 deliverable.
15 The remaining $1 million was due to the delay of completion of services milestones for two customers which are now expected to be 16 completed in Q4 . In both cases, the delays are expected to be no more than 60 to 90 days later than original commitments, with final 17 resolution around the end of November . Of this $8 million, we expect to see about 40 percent in Q4, about 30 percent in Q 1, with the 18 remainder being spread over a number of quarters beyond. As John noted, we are taking appropriate actions to strengthen our business 19 processes to mitigate the hurdles associated with these hybrid deals .
20 75 . Market reaction to Defendants' belated disclosures was swift and severe . In after-
21 hours trading on November 13, 2003, the price of Portal common shares fell more than 42 .5% to
22 open at $8 .77 per share on November 14, 2003, and have decreased more than 51% from a Clas s
23 Period high of $17 .93 per share reached less than a month before on October 15, 2003 .
24 76. The decline in Portal' s stock price near and at the end of the Class Period was a direct
25 result of the nature and extent of Defendants' prior misrepresentations, omissions and fraudulent
26 conduct concerning the Company's adverse business and financial conditions finally being revealed
27 to investors and the market . Lead Plaintiff and Pipefitters were damaged as a proximate result
28 thereof.
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1 Additional Admissions
2 77. On or about December 15, 2003, Portal filed its quarterly report Form 10-Q with the
3 SEC, for the three months ended October 31, 2003 (the "Q3 2004 10-Q") . The report, signed b y
4 defendant Bain, disclosed financial results that occurred during the Class Period.
5 78 . In the Q3 2004 10-Q, Portal revealed for the first time that during the Class Perio d
6 Portal had actually been using a self-described "proportional performance" method to recogniz e
7 certain revenue. In particular, the Q3 2004 10-Q stated :
8 For fixed price contracts on consulting services we recognize revenue on a proportional performance basis as determined by the relationship 9 of contract costs incurred to date and the estimated total contract costs, subject to meeting agreed upon milestones . 10 79. With respect to the Company's sales agreements that include both licensing and 11 services components, the Q3 2004 10-Q represented that Portal recognizes licensing revenues using 12 the percentage-of-completion method . However, the description of Portal's "percentage-of- 13 completion" method once again differed from that set forth in the prior quarter's 10-Q in that now 14 Portal's revenue recognition was based on costs incurred to date as a percentage of the total costs. In 15 particular, the Q3 2004 10-Q stated, in pertinent part, as follows : 16 For arrangements that do not meet the above criteria, both the license 17 revenues and services revenues are recognized under a contract accounting method in accordance with the provisions of SOP 81-1, 18 "Accounting for Performance of Construction Type and Certain Production Type Contracts." Portal follows the percentage-of- 1 9 completion method where reasonably dependable estimates of progress toward completion of a contract can be made . The Company 20 estimates the percentage-of-completion on contracts utilizing costs incurred to date as a percentage of the total costs at project 21 completion, subject to meeting agreed milestones . In the event that a milestone has not been reached, the associated cost is deferred and 22 revenue is not recognized until the milestone has been accepted by the customer. 23 80. In fact, none of Portal's prior disclosures revealed that the Company utilized cost s 24 incurred to date as a basis to recognize revenue. Rather, each of Portal's prior disclosure s 25 concerning its accounting policies expressly stated that Portal would base the percentage o f 26 completion on hours incurred to date - not costs. 27
28
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1 81 . This change in the disclosure of what occurred during the Class Period is significant
2 because it reveals that under either the Company's newly disclosed "proportional performance"
3 method or the Company's revised description of SOP 81-1, Portal could inflate the costs incurred to
4 date, and thereby inflate the revenue it was able to recognize, by simply claiming that its employees'
5 hourly billing rates were higher than they actually were . And that is exactly what Portal did.
6 82 . According to a Senior Business Analyst, Defendant Bain and other members o f
7 management required him to fabricate studies he performed concerning the hourly billing rates of
8 Portal's employees so that the Company could claim that the costs associated with its employees'
9 time on certain contracts were higher than they actually were . Because this resulted in a higher
10 percentage of costs incurred to date as compared to the estimated total contract costs, the Company
11 was able to recognize a greater proportion of revenue .
12 83 . In addition, when Portal filed its fiscal 2004 Form 10-K (the "2004 10-K") ,
13 Defendants admitted that Portal's policy for recognizing license revenues again had changed from
14 the policy disclosed to investors during the Class Period . The "revised" accounting policy admitted
15 that Portal needed to defer certain license revenue recognition when specific project milestones had
16 not been met. The Form 10-K stated in pertinent part as follows :
17 For multiple element arrangements that include software products, we allocate and defer revenue for the undelivered elements based on 18 their vendor-specific objective evidence ("VSOE") of fair value, which is generally the price charged when that element is sold 19 separately.
20 84. The Form 10-K disclosed that the Company was reducing its previously reporte d
21 revenues for Fiscal 2004 by at least $700,000, reflecting the deferral of revenues that Defendants ha d
22 recognized prior to approval of certain project specific milestones . The Form 10-K stated in
23 pertinent part as follows :
24 Our fourth quarter and fiscal 2004 revenues exclude $0 .7 million that we originally reported as revenues in our earnings release and 25 conference call dated February 24, 2004 . This revenue was associated with a customer who was, subsequent to the Company's 26 earning's release, unwilling to consent in writing that the Company has fully met all of the customer's expectations under the agreement 27 as of January 30, 2004 . The Company believes it has met and is in substantial compliance with all contractual requirements . Although 28 the cash associated with this revenue has been received by th e
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1 Company and the Company believes the customer has no right to a refund, the Company has decided to defer such revenue to reflect the 2 disagreement with the customer.
3 85 . Thereafter, on September 2, 2004, the Company issued a press release regarding it s
4 second quarter fiscal year 2005 results . In that press release, the Company revealed that its actua l
5 revenues were only approximately fifty (50%) percent of the Company ' s previously announce d
6 projections .
7 86. During a conference call with analysts held later that day, the Company revealed tha t
8 the issues that plagued the Company during the Class Period continued. In particular, according
9 to a transcript of the call published on Fair Disclosure Wire, Defendants indicated the following
10 reasons for the substantial revenue shortfall : (1) the Company "failed to reach agreement on
11 solutions delivery which precluded recognition of license revenue" with an unnamed customer ; (2)
12 in its dealings with Vodaphone, the Company had to account for certain solutions deliveries "as
13 product licenses rather than services as initially determined," which was "significant in that it results
14 in revenues not being recognized until final customer acceptance ;" and (3) the Company learned of
15 "several customer projects under delivery without agreed change orders . . . ."
16 87. Further, the Company announced that it was restating its first quarter fiscal year 200 5
17 financial statements due to "out-of-period adjustments ." As a result of this restatement, the
18 Company announced that it believed that its GAAP net loss for the first quarter of fiscal 2005 would
19 be adjusted to $6.0 million, or $0 .14 per share, compared to a net loss of $5 .2 million, or $0 .12 per
20 share, which was originally reported .
21 88. On the September 2, 2004 conference call, Portal admitted that it is still not able to
22 describe how it recognizes revenue . Specifically, Defendant Little stated:
23 Just one additional bit of color around that on the costs revenue . One of the things that I want to bring special attention to is the fact we 24 have kind of a hybrid license service model, which is a little bit of an undefined area in terms of revenue recognition. I mean, there's 87 .2 25 [ph] there's 91- 87 197 .2 [ph] in terms of revenue recognition and what ends up happening is the consequence of this is that the costs 26 and revenue is not matched up period to period .
27
28
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89. On September 16, 2004, Portal filed a report with the SEC on Form 8-K . The Form
2 8-K stated that the Company's certain previously filed financial statements should not be relie d
3 upon. In particular, the Form 8-K disclosed that:
4 On September 10, 2004, the Audit Committee of the Registrant approved that the following financial statements from the first quarter 5 of fiscal 2005 should not be relied upon : Unaudited Condensed Consolidated Financial Statements as of April 30, 2004 for the 6 Condensed Consolidated Balance Sheet, for the three month period ended April 30, 2004 for the Condensed Consolidated Statements of 7 Operations, for the three month period ended April 30, 2004 for the Condensed Consolidated Statements of Cash Flows and the related Notes to Condensed Consolidated Financial Statements . Accordingly, the financial statements for the period ended April 30, 9 2004 that have been included in the Company's Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on 10 June 9, 2004 or included in previous announcements should not be relied upon. The Audit Committee discussed this conclusion with the 11 Registrant's independent auditors, Ernst & Young LLP .
12 90. Following the revelation of the fraud, Defendants Bain and Little both left th e
13 Company .
14 Portal' s Financial Statements and Financial Disclosures during the Class 15 Period Were Materially False and Misleading
16 91 . At all relevant times during the Class Period , Portal represented that its financial
17 statements were prepared in accordance with GAAP .2 These representations were materially false
18 and misleading because Portal employed deceptive revenue recognition practices during the Class
19 Period. Now, defendants are engaged in a game of "hide the ball" in their attempt to cover up
20 Portal's deceptive revenue recognition practices during the Class Period.
21 Portal's Deficient Internal and Disclosure Controls
22 92. GAAP, as set forth in Financial Accounting Standards Board ("FASB") Statement o f
23 Concepts ("Concepts Statement") No . 1, provides that a fundamental objective of financial reportin g
24
25 2 GAAP are those p nciples recognized by the accounting profession as the conventions , rules, and 26 ri procedures necessary to define accepted accounting practice at a particular time. Regulation S-X [17 C.F.S §210 .4-01(a)(1)] states that financial statements filed with the SEC that are not prepared in 27 conformity with GAAP are presumed to be misleading and inaccurate ." 28
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is to provide investors with information that is useful in making investment decisions . Concepts
2 1 Statement No . 1, X34, states:
Financial reporting should provide information that is useful to present and potential investors and creditors and other users in 4 making rational investment, credit, and similar decisions . The information should be comprehensible to those who have a 5 reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence . 6 [Emphasis added.]
7 93 . Indeed, FASB's Concept Statement No. 2 stated that the usefulness of financial
8 information for decision making should be the primary quality of financial reporting .
9 94. In violation of these provisions of GAAP, Portal's revenue recognition practices
10 during the Class Period were not understood by even seasoned securities analysts who followed the
11 Company for years . For example, shortly after the end of the Class Period, on November 13, 2003,
12 Michael Turits, an analyst with Prudential Securities, questioned management about Portal's Class
13 Period revenue shortfall on a conference call with securities analysts :
14 Q. I'm sorry to do this, but John you just went through your remarks pretty quickly. Maybe the other guys got it, but I just didn't . 15 Can you go through those issues a bit more carefully - or Howard - on what the timing issues were and the service issues ; just detail them 16 as best you can for us a bit more more slowly ?
17 A. (Defendant John Little) I gave four examples of timing issues, and we're going to get into these in more detail at the earnings call 18 next week. But the four that I mentioned were delayed revenue of licenses on already existing contracts, where we find out, for 19 example, that under current rules, we would not be able to recognize revenue until entire projects are delivered in some future quarter. The 20 second was -
21 Q. You couldn't recognize it until the project was done ?
22 A. (Defendant John Little) Right . You can recognize services on an ongoing basis but license revenue may not be recognizable until 23 the entire project is delivered and accepted.
24 Q . Why is that? Aren 't these projects you're doing on a percentage completion basis? That is how I understood you were 25 doing these projects .
26 A. (Defendant Howard Bain) Revenue recognition rules are increasingly complex on this . 27
28
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1 Q. Simple thing -My understanding . . . the way you guys have been talking about these projects were that you're doing them on a 2 percentage completion basis. Has that changed ?
3 A. (Defendant Howard Bain) No.
4 Q . So you're still doing it on a percentage completion basis but you are telling us you can't recognize it until the project is done ? 5 A. (Defendant John Little) With percentage completion based 6 on milestones, so that's important that you understand that. It's not based on cost input, but milestones. If milestones are not accepted 7 by customers, there's no revenue recognition.
8 Q. So were the milestones not accepted?
9 A. (Defendant Howard Bain) That also does not apply to the license revenue recognition component - they are treated 10 independently .
11 Q. So now you're saying that license revenue couldn't get recognized on a percentage of completion basis until the entire deal 12 is done, or on milestones - Which is it?
13 A. (Defendant John Little) Different projects are done in different ways. 14 Q. So in some cases it was milestones; some until the projects 15 were done ?
16 A. (Unknown Speaker) That's correct. Unfortunately it's very complex. But we are having those kinds of situations - each of those 17 kinds of situations.
18 95 . Indeed, the confusion experienced by the Prudential Securities analyst regardin g
1 9 Portal's revenue recognition practices during the Class Period was entirely understandable given
20 defendants vague and erroneous responses to questions posed to them by analysts and Portal's
21 continually changing financial statement disclosures concerning its revenue recognition polices . In
22 fact, in direct contradiction of the above representations, several months later, in its audited
23 financial statements for the year ended January 31, 2004 filed with the SEC after the end of the Class
24 Period, Portal disclosed that "[t]o date" it had not accounted for any contracts utilizing the
25 percentage of completion method of accounting under SOP 81-1.3 Accordingly, Portal's audited
26
27 3 Portal's audited financial statements for the year ended January 31, 2004, disclosed: "To date, Portal has had no contracts accounted for under SOP 81 .1 ." The American Institute of Certifie 28 d
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financial statements affirmatively contradicted the representations made by defendants Little and
2 Bain to securities analysts just months prior when they were questioned about Portal's third quarter
3 2004 revenue shortfall . Indeed, defendants' contradictions were an attempt to mask Portal's
4 improper Class Period revenue recognition practices noted below .
5 96. Defendants have continued their Class Period revenue recognition shell game . For
6 example, in its financial statements for the quarter ended October 31, 2003, Portal newly disclose d
7 that it utilizes a "proportional performance basis" of accounting for its fixed priced service contracts .
8 Then, more recently, in its financial statements for the quarter ended July 31, 2004, Portal disclosed:
9 Custom software development arrangements which do not include license arrangements are generally recognized as follows except 10 when the Company determines that the custom developed software will be made available to other customers . The Company recognizes 11 time and materials service contracts as the services are performed . Fixed price services contracts are recognized on a proportional 12 performance basis as determined by the relationship of contract costs incurred to date and the estimated total contract costs, which are 13 regularly reviewed during the life of the contract, subject to meeting agreed upon milestones which have been formally accepted by the 14 customer. In instances where the Company has determined that it intends to make the custom developed software available to other 15 customers, the Company defers revenue recognition until delivery and acceptance of the software by the customer. Costs incurred to 16 develop the software to be made available to other customers are expensed as incurred to research and development expense . 17 97. These new disclosures evidence Portal's obfuscation of its revenue recognitio n 18 practices during the Class Period . 19 98. Indeed, Congress enacted the Sarbanes-Oxley Act of 2002 ("SOX"), in part, t o 20 heighten the responsibility of public company senior managers and directors associated with the 21 quality of financial reporting and disclosures made by their companies . For example, Section 906 o f 22 SOX, in pertinent part, provides : 23 (a) CERTIFICATION OF PERIODIC FINANCIAL REPORTS 24 Each periodic report containing financial statements filed by an issuer with the Securities Exchange Commission pursuant to section 13(a) 25 or 15(d) of the Securities Exchange Act of 1934 (15 U .S.C. 78m(a) o r
26
27 Public Accountants ("AICPA") Statement of Position ("SOP") No. 81-1, provides guidance in accounting for contacts utilizing the "percentage-of-completion method" of accounting . 28
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78o(d)) shall be accompanied by a written statement by the chief executive officer and chief financial officer (or equivalent thereof) of 2 the issuer.
(b) CONTENT The statement required under subsection (a) shall certify that the periodic report containing the financial statements 4 fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U .S.C 78m or 78o(d) and that information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations 6 of the issuer .
(c) CRIMINAL PENALTIES - Whoever
(1) certifies any statement as set forth in subsections (a) and (b) of this section knowing that the periodic report accompanying 9 the statement does not comport with all the requirements se t forth in this section shall be fined not more than $1,000,000 or 10 imprisoned not more than 10 years, or both; or
11 (2) willfully certifies any statement as set forth in subsections (a) and (b) of this section knowing that the periodic report 12 accompanying the statement does not comport with all the requirements set forth in this section shall be fined not more 13 than $5,000,000, or imprisoned not more than 20 years, or both. 14 99 . In addition, SEC promulgated Item 307 of Regulation S-K [17. C.F.R. §229.307] 15 which provides that: 16 a) The conclusions of the registrant's principal executive and 17 principal financial officers, or persons performing similar functions, regarding the effectiveness of the small business issuer's disclosure 18 controls and procedures (as defined in Rule 13a 14(c) or Rule 15d 14(c) of this chapter) based on their evaluation of these controls and 19 procedures as of a date within 90 days of the filing date of the quarterly or annual report that includes the disclosure required by this 20 paragraph. ; and
21 b) Disclose whether or not there were significant changes in the registrant's internal controls or in other factors that could 22 significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant 23 deficiencies and material weaknesses .
24 100. As a result of the forgoing requirements, Portal's Class Period Forms 10-Q falsel y
25 disclosed:
26 As of the end of the quarter ended . . ., the Company 's management, including its chiefexecutive officer and chieffinancial officer, has 27 evaluated the effectiveness of the Company's disclosure controls and procedures, as such term is defined in Rule 13a-15(e) or Rule 28 15d-15(e) promulgated under the Securities and Exchange Act o f
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1934, as amended. Based on that evaluation, the Company's chief executive officer and chief financial officer concluded that the 2 Company's disclosure controls andprocedures were effective as of . . . to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized and 4 reported within the time periods specified in Securities and Exchange Commission rules and forms . [Emphasis added.]
101 . These false and misleading representations were then falsely certified by defendant s 6 Little and Bain in Portal's Class Period Forms 10-Q :
I, . . ., certify that:
1 . I have reviewed this quarterly report on Form 10 Q of Portal 9 Software, Inc. ;
10 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a 11 materialfact necessary to make the statements made, in light of the circumstances under which such statements were made, not 12 misleading with respect to the period covered by this quarterly report; 13 3 . Based on my knowledge, the financial statements and other 14 financial information included in this quarterly report fairly present in all material respects the financial condition, results ofoperations 15 and cash flows of the registrant as of, and for, the period presented in this quarterly report; 16 4 . The registrant's other certifying officer and I are 17 responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a 14 and 15d 18 14) for the registrant and we have :
19 a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, 20 including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period 21 in which this quarterly report is being prepared ;
22 b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 23 days prior to the filing date of this quarterly report (the "Evaluation Date") ; and 24 c) Presented in this quarterly report our conclusions 25 about the effectiveness of the disclosure controls and procedures base on our evaluation a of the Evaluation Date , 26 5 . The registrant's other certifying officers and I have disclosed, 27 based on our most recent evaluation, to the registrant's auditors and audit committee of the registrant's Board of Directors (or persons 28 performing the equivalent function):
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a) All significant deficiencies in the design or operation of internal controls which could adversely affect the 2 registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors 3 any material weaknesses in internal controls; and
4 b) Any fraud, whether or not material, that involves management or other employees who have a significant role 5 in the registrant's internal controls ; and
6 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes 7 in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses . 9
10 By: /s/ JOHN E. LITTLE John E. Little 11 Chief Executive Office r
12 By: /s/ HOWARD A. BAIN III 13 Howard A . Bain III Chief Financial Officer 14 102 . Portal Software's Class Period Forms 10-Q also contained the following false and 15 misleading certifications by defendants Little and Bain : 16 Certification of Chief Executive Officer and Chief Financial 17 Officer Pursuant to 18 U .S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes Oxley Act of 200 2 18 In connection with the Quarterly Report of Portal Software, Inc . (the 19 "Company") on Form 10 Q for the period ended ...as filed with the Securities and Exchange Commission on the date hereof (the 20 "Report"), I, John E . Little, Chief Executive Officer of the Company, certify, pursuant to 18 U .S .C. Section 1350, as adopted pursuant to 21 Section 906 of the Sarbanes Oxley Act of 2002, that :
22 (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 23 1934; and
24 (2) The information contained in the Report fairly presents, in all material respects, the financial condition and 25 result of operations of the Company .
26 By: /s/ JOHN E. LITTLE John E. Little 27 Chief Executive Officer
28
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By: /s/ HOWARD A . BAIN III Howard A . Bain III Chief Financial Officer
103 . The above representations and defendant certifications were materially false an d
4 I misleading when made because, as defendants knew or recklessly disregarded, Portal's financia l
statements were not prepared in accordance with GAAP and Portal's internal and disclosure control
6 were not operating effectively during the Class Period.
104. Indeed, Portal's internal control deficiencies existed even well after the end of th e
Class Period . For example, on a September 2, 2004 conference call between defendants Bain and
Little and securities analysts held to discuss Portal's results for the quarter ended July 31, 2004,
10 defendant Little admitted that Portal entered into transactions prior to receiving signed agreements
11 with its customers :
12 Q 1 . (Scott Sutherland, Wedbush Morgan Securities) First of all, when you look at these deals, the three reasons you missed and you end up 13 missing the quarter, what do you see the timeline of that falling out? For example, large licensing deals, is that something that now has 14 signoff for this quarter, and there were several smaller deals that actually made you miss your revised guidance? Is that something 15 that you guys need to better understand how that's going to be recognized? Can you talk about how the fallout is? Are these multi- 16 quarters and the revenues comes from these deals now, or is it a lot of this in the next two quarters ? 17 A. (John Little) Yeah Scott, let me walk through some of this . I'll 18 ask Howard to step up with more detail . The licensed transaction without the statement of work, we would normally expect to conclude 19 in 3Q of this year. Lot of times it's easier to get a license deal negotiated than a services deal, which has a complicated statement 20 work involvement. I think we could have done better around that, but that looks like a 3Q deal now to our best guess . Things like the 21 license revenue recognition around the Vodafone GFA will actually take - could take multiple quarters to recognize . There are a lot of 22 things around the timing of acceptance test with Vodafone that have nothing to do with Portal and we're dependent, for example, upon 23 efforts of system integrators, as well as the customer for that . So, we can delivery the components, they can sit there for a while, can be 24 integrated, can work, but we haven't gone through the formal user acceptance testing, which requires third party efforts . So that is one 25 of the reasons that we talked the, you know, timing of the revenue around these customer transactions, not always matching the actual 26 delivery because there is dependency on third parties .
27 I should point out for both the first transaction and the second transaction, first category and the second category, we are receiving 28 cash from them, so the customer certainly is happy enough, they ar e
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writing us big checks . We got 100% of license payment around our first transaction, so not only shows customer satisfaction, it's a pretty 2 good indication that there is continued stuff happening . Around the third area, the significant work we're doing without benefits of statements of work and contracts and change orders, I described that as a combination of lack of project discipline and a strong 4 desire by the field people to make the customers happy . And so there is always kind of on the one hand, on the other with that. I really encourage them to make customers happy . I encourage them to make the company investors happy as well by signing change orders and statements of work. So that, I think, is an effort of applying more discipline and process to actual customer engagements to make sure customer agreements are signed. While predicting the future is, with 100% accuracy is difficult ; I would expect that the vast majority of all those projects end up having statements work and contracts. The work was done in response to 9 something the customer needs, we already have in most cases, probably in every case, existing agreements with the customers, 10 essentially just running the paperwork through, getting signed off and negotiating the actual pricing. 11 I mentioned that we're hiring, we have hired a number of executives, 12 partner level people to work with customers . I think that count also is spending a great deal of time . Some sense for them, this is easy 13 money. We have a customer relationship ; we've done the work . We have to get a signature, and you know, a signature around 14 specifications . That's a reasonably straightforward process . So, I think a lot of this ends up being timing issues, not necessarily, an 15 adverse, a completely adverse effecting the current quarter . . . .
16 105. Indeed, GAAP requires that financial statements disclose significant risks an d
17 I uncertainties associated with an entities business. AICPA's SOP No. 94-6.
18 106. Nonetheless, in violation of GAAP, Portal's Class Period financial statement s
1 9 improperly failed to disclose that its internal controls were so deficient that it routinely committed
20 Company resources to significant projects p rior to obtaining signed customer agreements. In so
21 doing, Portal and the Individual Defendants filed documents with the SEC that were mate rially false
22 and misleading and violated provisions of GAAP, SOX and Regulation S-K.
23 107. In addition to the material internal and disclosure control deficiencies noted above ,
24 I after the end of the Class Period, Portal disclosed that during the Class Period : 25 Fixed price services contracts are recognized on a proportional performance basis as determined by the relationship of contract costs 26 incurred to date and the estimated total contract costs, which are regularly reviewed during the life of the contract, subject to meeting 27 agreed upon milestones .
28
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1 108 . Indeed, prior to this disclosure , Portal's financial statements, in violation of GAAP,
2 failed to disclose that it recognized revenue on fixed priced, service contracts on a "proportiona l
3 performance" basis .
4 109 . Indeed, GAAP, in APB Opinion No. 22, ¶7, provides that the usefulness of financia l
5 statements in making economic decisions depends significantly upon the user 's understanding of the
6 accounting policies followed by a company . In fact, GAAP states that information about the
7 accounting policies adopted by a reporting company is "essential" for financial statement users .
8 (APB Opinion No. 22, ¶8 .)
9 110. Accordingly, GAAP, in paragraph 12 of APB Opinion No . 22 provides :
10 In general, the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and 11 allocation of asset costs to current and future periods ; in particular, it should encompass those accounting principles and methods that 12 involve any of the following:
13 a. A selectionfrom existing acceptable alternatives ;
14 b. Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are 15 predominantly followed in that industry ;
16 c. Unusual or innovative applications of generally accepted accounting principles (and, as applicable, of principles and methods 17 peculiar to the industry in which the reporting entity operates) requires that financial statements identify and describe important 18 judgments as to the appropriateness of principles relating to the recognition of revenue. [Emphasis added .] 19 111 . As defendants knew or recklessly ignored, Portal failed to provide the disclosur e 20 required by GAAP associated with its "proportional performance basis" revenue recognition policy 21 during the Class Period . Indeed, it was imperative for Portal to describe its "proportional 22 performance basis" of revenue recognition because little, if any, authoritative GAAP associated with 23 such revenue recognition policy currently exists . In fact, GAAP, in SEC Staff Accounting Bulletin 24 ("SAB") No . 104, provides that "[iJf sales transactions have multiple units of accounting, such as 25 products and service, the accountingpolicy should clearly state the accounting policy for each 26 unit of accounting as well as how units of accounting are determined and valued ." Nonetheless, 27
28
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Portal's Class period financial statements failed fully and fairly describe its policy of revenu e 21 recognition.
112. In the above ways, Portal failed to provide the disclosure required by GAAP and the
4 I rules and regulations administered to the SEC. Defendants compounded such material omission s
5 when Portal falsely represented, and the individual defendants falsely certified, that Portal' s
6 I disclosure controls were operating effectively, when they were not.
7 113 . Indeed, the following dialog on a September 2, 2004 conference call betwee n
8 defendants Bain and Little and securities analysts held to discuss Portal's results for the quarte r
9 ended July 31, 2004 evidences the ineffectiveness of the Company's disclosure controls during th e
10 Class Period:
11 (Mark Griffin, Prudential Equity Group, LLC) I understand the difference, statement of work and all of that . This problem started 12 four quarters ago i.e. [during the Class Period] when you had a 24% quarter over quarter decline last October . And it had to do 13 with this license - I mean how are we working it out so that deals that are signed today or were signed this past quarter don't have 14 these problems later? Because you keep saying the same thing. This is three quarters in a row where you haven 't been able to meet 15 your guidance; you have not figured out where, you know, the revenues will come in. You haven 't figured out how the contracts 16 are supposed to work, and how to get those statements of work signed, and all those details that are in the contracts. Have you 17 figured out how to get those contracts written right , and how is that going to work going forward? 18 (Howard Bain) You know, I think that you bring up a really good 19 point on that. I'll split this into two categories . The first category I split into, you know, just need for improved execution, especially 20 around these much larger, much more complicated transactions to make sure that - - - You know, we do the workshops, we do the 21 detailed statement of works, we have enough program management to go through and recognize requests for change orders and process 22 those in a reasonable period of time . And one thing we've determined from our own in-house investigation is that the very 23 largest contracts for us, very largest engagements, longer term ones, tend to have more of these issues kind of popping up, so we're 24 making some very specific changes in the way we do those large contracts, largely driven by the way we're hiring senior experienced 25 people from places like ex-Deloitte people, ex-Accenture people, people from other system integrators, that are use to doing these large 26 projects. So very much a focus of that, I would describe that as kind after pure execution issue . 27 In the terms of the timing of the revenue recognition, the expenses, 28 that's not a contract issue . There is nothing we can do to the contract
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to say it's going to shift into one or the other. It's a consequence of the way we do total solutions, which is a significant chunk of license, 2 plus a significant chunk of services business . And the way- - - especially the fact that when we do these engagements with customers, we do enhancements for them based on our standard product where we own the intellectual property, it's folded back into 4 the standard code stream, and it appears that some future time in a product release . Tremendous benefit to the customers, really strong differentiation. It's in many ways the break through that we've been able to accomplish in engineering, but it does mean that the expenses 6 will show up as incurred in terms of R&D around, R&D expense and the revenue from that will show up as licensed at some future time 7 when the customer has been through user acceptance testing . It won't be milestone based. It won't be percentage of completion based . It 8 will be treated as a product and that's an inevitable consequence of the way we're doing business, and that will continue for the 9 indefinite future .
10 (Mark Griffin, Prudential Equity Group, LLC) Well, wasn't only the few quarters ago, the problem was milestone based and now you're 11 changing how that works? Is that--
12 (Howard Bain) Good question . What we had determined more and more is that our ability to manage the development of these 13 enhancements and fold it back into the standard code stream was actually quite a bit better than, and the customer demand for that was 14 quite a bit stronger than we had thought two or three quarters ago . Whereas several quarters ago, we thought that interesting percentage 15 of the work we did would be kind of one off per customer . It's now still driven very much by need for customers like Vodafone, but it 16 turns out that the processes and so forth evolved to the point where it all just gets folded back in the standard code stream . As you know, a 17 lot of historical companies have gotten into trouble by having a lot of different threads, a lot of different customer versions, every customer 18 gets a different version of software . We have solved that problem in a way that all the customers are part of a standard code stream and if 19 we have to fork off something for like Vodafone, it merges back in a future release and returns back to the standard product . So it's a 20 really nice breakthrough, a really strong sales proposition for the customer, but it does mean that it gets treated like license revenue 21 because it's now part of a product, or will be part of the product, rather than one off services engagement. 22 Portal's Improper Recognition of Revenue 23 114. During the Class Period, Portal represented that it accounted for its licensing revenu e 24 pursuant to the requirements of SOP 97-2 and SOP 98-9 . As noted herein, however, suc h 25 representations were false and misleading in numerous respects . 26 115 . As noted above, since at least fiscal 2003, Portal has focused its marketing efforts o n 27 larger, more sophisticated customers . A former Portal Controller explained to Lead Plaintiff tha t 28
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1 Portal's larger customers often insisted on certain software features that required significan t
2 production, modification or customization of the Company's existing software and required Portal to
3 make significant "rewrites" of the software prior to implementation.
4 116. The former Portal Controller further advised Lead Plaintiff that such significan t
5 I "rewrites" and "customizations" of the Company's software created "a problem" for Portal in term s
6 of revenue recognition because, as noted below , SOP 97-2 prohibited Portal from recognizing
7 license fee revenue when it delivered the license to its customer, which had been its practice .
8 117. SOP 97-2,' 74 provides that :
9 If an arrangement to deliver software or a software system, either alone or together with other products or services, requires significant 10 production, modification or customization of the software, the service element does not meet the criteria for separate 11 accounting . . . [and tJhe entire arrangement should be accounted for in conformity with ARB No. 45, using the relevant guidance in 12 SOP 81-1 .4 [Emphasis and footnote added .]
13 118. Since many of Portal's larger customers insisted on certain software features that
14 required significant production, modification or customization of the Company's existing software,
15 license fee revenue which Portal historically recognized when it delivered the license to its customer,
16 would now have to be delayed and recognized as the contract progressed to completion pursuant to
1 7 the percentage-of-completion method in accordance with SOP 81-1 .
1 8 119. In an attempt to evade the above provision of SOP 97-2, the former Portal Controlle r
19 1 said that the Company began to split many agreements with the same customer into a
20 "developmental" and "production" licenses. The former Controller advised Lead Plaintiff that :
21 [During fiscal 2004]Portal split the way it recognized revenue on the licensing of its software . This split was intended to help Portal 22 recognize revenue upfront on these more complex and time- consuming deals . Portal began to recognize a developmental license 23 and a production license, at the same time .
24
25 4 ARB No. 45 provides guidance in accounting for long-term construction-type contracts . Pursuant to ARB No. 45, such contracts are accounted for utilizing the "percentage-of-completion method" or 26 "the completed-contract method." The percentage-of-completion method recognizes income as work on a contract progresses and the completed-contract method recognizes income only when the 27 contract is substantially completed. 28
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1 Portal was recognizing large amounts for the developmental software , and then reconfiguring the software for the customer. Portal was 2 recognizing the bulk of the revenues upfront, and using the production license as the more nominal of the two types of licens e 3 agreements . This creates a problem with revenue recognition because a company is not supposed to recognize revenue on software until 4 theprogram is completely written . [Portal] can implement software in a fashion necessary for its successful operation, but [Portal could 5 not] rewrite the program. Ernst and Young changed its position on Portal's determination, and shortly thereafter, the shortfall in 6 earnings came, and the stock price dropped .
7 120 . Portal's attempt to bifurcate its software arrangements into separate legal
8 arrangements for no purpose other than to increase its reported revenues evidences the revenue
9 reporting pressures experienced by Portal's management and defendants willingness to inflate
10 Portal's financial results during the Class Period. In fact, the former Controller stated Portal began
11 drafting contracts that were so convoluted that the present and future contractual obligations could
12 not be discerned . Nonetheless, these contracts became the pretext by which the Company
13 improperly accelerated revenue recognition during the Class Period .
14 121 . In fact, defendants were so brash in their quest to overstate Portal's operating results
15 during the Class Period, that they directed or acquiesced in Portal's false assignment of higher prices
16 to "developmental" licenses and lower prices to "production" licenses than historically had been the
17 case so that the Company could front load its reported revenue .
18 122 . Despite such machinations, GAAP, in §5100 .39 of the AICPA's Technical Practice
19 Aids ("TPA") specifically required Portal to account for its production and development licenses as
20 a single contracts :
21 Inquiry - Software vendors may execute more than one contract or agreement with a single customer. Should separate contracts or 22 agreements be viewed as one multiple-element arrangement when
23 24 5 To the extent that defendants may claim that Portal's developmental and production licenses fall outside the scope of SOP 97-2, GAAP, in FASB's Emerging Issues Task Force ("EITF") Abstract . 00-21 provides guidance in accounting for arrangements in which a vendor is to perfor m 25 Nomultiple revenue generating activities . EITF Abstract No. 00-21 provides that "separate contracts 26 with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement i n 27 considering whether there are one or more units of accounting . That presumption may be overcome if there is sufficient evidence to the contrary ." 28
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1 determining the appropriate amount of revenue to be recognized in accordance with SOP 97-2, Software Revenue Recognition? 2 Reply - A group of contracts or agreements maybe so closely related 3 that they are, in effect, parts of a single arrangement . The form of an arrangement is not necessarily the only indicator of the substance of 4 an arrangement. The existence of any of the following factors (which are not all-inclusive) may indicate that a group of contracts 5 should be accountedfor as a single arrangement:
6 • The contracts or agreements are negotiated or executed within a short time frame of each other. 7 • The different elements are closely interrelated or interdependent in terms of 8 design, technology, or function. 9 • The fee for one or more contracts or agreements is subject to refund or forfeiture or 10 other concession if another contract is not completed satisfactorily.
11 • One or more elements in one contract or agreement are essential to the functionality of an element in another contract. 12 • Payment terms under one contract or agreement coincide with performance criteria 13 of another contract or agreement . 14 • The negotiations are conductedjointly with two or more parties (for example, from 15 different divisions of the same company) to do what in essence is a single project. [Emphasis added.] 16 123 . Other former Portal employees have confirmed that defendants routinely manipulate d 17 Portal's revenue recognition practices during the Class Period in order to inflate the Company's 18 reported revenues. For example, a former Portal Accountant stated that defendants routinely 19 manipulated Portal's license fee recognition practices during the Class Period and specifically 20 identified those revenues related to Portal's contracts with Onstar as being materially overstated 21 during the third quarter of fiscal 2004 . 22 124. In addition, a former Portal Senior Business Analyst indicated that the Company' s 23 revenue numbers were "cooked ." In fact, the Senior Business Analyst advised Lead Plaintiff that 24 Portal 's management "would tell me what the results of the analysis needed to be before I even 25 started it." The confidential witness also stated the many of his/her former co-workers at Portal 26 complained about such practices and the certain of them werefired when they did not generate 27 the results demanded by management. As a result, the analyses that management asked Portal 28
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1 employees to prepare were "reverse engineered " to hit predetermined targets established by
2 I management. 3 125 . Indeed, the former Senior Business Analyst admitted : "if that [his/her] analysis was
4 ever held up to any scrutiny by the auditors, I don't think there is any way it could have passed
5 because, basically, I reversed engineered it through some very selective querying of the database ."
6 In fact, when the former Senior Business Analyst explained to management that his/her analysis was
7 contrived and had no basis in reality, they replied that "they did not care!" "As long as I came u p
8 with the numbers they wanted, they were happy and did not want to know how I got it ."
9 126 . For example, the former Senior Business Analyst explained that he/she routinel y
10 prepared analyses at the request of defendant Bain and other members of management which inflated
11 the billing rates of Company employees in connection with service contracts performed in foreign
12 countries . The confidential witness also stated he/she accomplished management's request by
13 "selectively querying" Portal's database and cherry picking only the data which would generate a
14 result that matched management's demand . The Company would then use contrived analysis to
15 I inflate its reported revenue .
16 127. During the Class Period, the Senior Business Analyst said the analyses he/she
17 prepared falsified employee billing rates on "six to ten" of Portal's contracts totaling approximately
18 $5 million for work performed in Greece, Italy, Columbia and Spain, including Portal's contract with
19 Columbia Mobile.
20 128. As defendants knew or recklessly ignored, SOP 97-2 provides that revenue on
21 software arrangements must be allocated to each of its various elements based on VSOE of the
22 element's fair value. As noted in SOP 97-2, such evidence of fair values is limited to the pric e
23 charged when the element is sold separately or is to be sold separately . As defendants knew, or
24 recklessly ignored, the falsified billing rates Portal utilized during the Class Period did not reflect its
25 fair value and the analysis which was "reversed engineered" did not represent its true VSOE .
26 129. During the Class Period, defendant knew or recklessly ignored that the improper
27 revenue recognition practices alleged herein caused Portal to violate SOP 97-2 and TPA §5100 .39.
28 Indeed, the SEC has issued numerous statements to its registrants, their auditors and to accountin g
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and auditing standards-setters warning them to be ever vigilant about the fairness of financia l
I reporting practices in general and revenue recognition practices in particular after having witnesse d
I alarming financial reporting abuses prior to the Class Period .
130 . Now, defendants have continued their deceptive financial reporting by failing t o
restate Portal's erroneous Class Period financial statements . GAAP, in APB Opinion No . 20,
provides that previously issued financial statements that are erroneous due to the misapplication of
accounting principles are to be retroactively restated. In violation of GAAP, Portal has corrected its
improper premature revenue recognition practices during the Class Period by managing and
9 adjusting its post Class Period revenues rather than restating its Class Period financial statements in
10 accordance with GAAP.
11 131 . As noted in FASB Concepts Statement No . 2 :
12 Information about an enterprise gains greatly in usefulness if it can be compared with similar information about other enterprises and with 13 similar information about the same enterprise for some other period or some other point in time . 14 132 . By failing to restate its previously issued materially false and misleading Class Perio d 15 financial statements in conformity with GAAP, Portal and the individual defendants knowingly or 16 recklessly continued their pattern of deceiving investors by denying them the ability to meaningfully 17 compare the Company's current operating performance against its comparable prior periods or with 18 that of its competitors . 19 133 . Defendants had the responsibility to select and fully disclose accounting principle s 20 that were appropriate to reflect Portal's business activities . Defendants also had the responsibility to 21 design, implement, and maintain a system of internal accounting controls that would provide 22 accounting records to appropriately reflect the transactions of Portal in accordance with Section 13 23 of the Exchange Act of 1934. 24 134. Notwithstanding these regulations, Defendants engaged in violations of GAA P 25 I resulting in the material overstatement of Portal's operating performance during the Class Period. In 26 addition to the accounting improprieties stated above, Portal presented its financial statements durin g 27 the Class Period in a manner which also violated at least the following provisions of GAAP: 28
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a. The concept that financial reporting should provide information that is useful to present and potential investors and 2 creditors and other users in making rational investment, credit and similar decisions (Concepts Statement No . 1,¶34); 3 b. The concept that financial reporting should provide 4 information about the economic resources of an enterprise, the claims to those resources, and the effects of transactions, events and 5 circumstances that change resources and claims to those resources (Concepts Statement No . 1, ¶40); 6 c. The concept that financial reporting should provide 7 information about how management of an enterprise has discharged its stewardship responsibility to owners (stockholders) for the use of enterprise resources entrusted to it . To the extent that management offers securities of the enterprise to the public, it voluntarily accepts 9 wider responsibilities for accountability to prospective investors and to the public in general (Concepts Statement No . 1, ¶50); 10 d. The concept that financial reporting should provide 11 information about an enterprise's financial performance during a period. Investors and creditors often use information about the past 12 to help in assessing the prospects of an enterprise . Thus, although investment and credit decisions reflect investors' expectations about 13 future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance 14 (Concepts Statement No . 1, ¶42);
15 e. The concept that financial reporting should be reliable in that it represents what it purports to represent . That information should be 16 reliable as well as relevant is a notion that is central to accounting (Concepts Statement No . 2, ¶¶58-59) ; 17 f. The concept of completeness, which means that nothing is left 18 out of the information that may be necessary to ensure that it validly represents underlying events and conditions (Concepts Statement No. 19 2, ¶79);
20 g. The concept that conservatism be used as a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in 21 business situations are adequately considered. The best way to avoid injury to investors is to try to ensure that what is reported represents 22 what it purports to represent (Concepts Statement No . 2, ¶¶95, 97).
23 135 . In failing to file financial statements with the SEC which conformed to the
24 requirements of GAAP, Portal disseminated financial statements that were presumptively misleading
25 and inaccurate . Indeed, defendants' failure to restate Portal's materially false and misleading Class
26 Period financial statements evidence the defendants' intent to deceive investors during the Class
27 Period and misrepresent the truth about the Company and its business , operations and financial
28 performance to detriment of those who relied on them .
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1 136. The Company's Class Period Forms 10-Q filed with the SEC were also materially
2 false and misleading in that they failed to disclose known trends, demands, commitments, events,
3 and uncertainties that were reasonably likely to have a materially adverse effect on the Company's
4 liquidity, net sales, revenues and income from continuing operations, as required by Item 303 of
5 Regulation S-K.
6 Applicability of Presumption of Reliance : Fraud-on-the-Market Doctrin e 7 137 . At all relevant times, the market for Portal's securities was an efficient market for the 8 following reasons, among others : 9 (a) Portal's stock met the requirements for listing, and was listed and actively 10 traded on the NASDAQ, a highly efficient and automated market ; 11 (b) As a regulated issuer, Portal filed periodic public reports with the SEC and th e 12 NASD; 13 (c) Portal regularly communicated with public investors via established market 14 communication mechanisms, including through regular disseminations of press releases on the 15 national circuits of major newswire services and through other wide-ranging public disclosures, such 16 as communications with the financial press and other similar reporting services ; and 17 (d) Portal was followed by several securities analysts employed by major 18 brokerage firms who wrote reports which were distributed to the sales force and certain customers of 19 their respective brokerage firms . Each of these reports was publicly available and entered the public 20 marketplace . 21 138. As a result of the foregoing, the market for Portal's securities promptly digested 22 current information regarding Portal from all publicly available sources and reflected such 23 information in Portal's stock price . Under these circumstances, all purchasers of Portal's securities 24 during the Class Period suffered similar injury through their purchase of Portal's securities at 25 artificially inflated prices and a presumption of reliance applies . 26
27
28
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1 Plaintiffs Were Damaged When Portal's Artificially Inflated Stock Price Declined After Investors Learned of Portal's Previously Undisclosed True Business and Financial 2 Condition
3 139. Each of Defendants' materially false and misleading statement detailed herein cause d
4 the price of Portal stock to be artificially inflated. As a result, each of the investors that purchased
5 Portal stock during the Class Period paid an inflated price . Company insiders took advantage of this
6 artificial inflation in the stock price by selling their personally held shares for proceeds of
7 $5,045,202. In addition, Portal completed its $60 million Secondary Offering at artificially inflated
8 prices.
9 140. As demonstrated in the following chart, when Defendants began to reveal to investor s
10 and the market the truth concerning Portal's adverse business and financial condition that previously
11 had been concealed by Defendants' misstatements, omissions and other fraudulent conduct, the price
12 of Portal's stock declined significantly . Specifically, defendants had been prematurely recognizing
13 revenue by improperly categorizing their licensing revenue (1164a) ; overstating purported billing
14 rates (¶64b); manipulating the necessary vendor specific objective evidence of the fair value of all
15 undelivered items (¶64c) ; and prematurely recognizing revenue before specific project milestones
16 were met (¶64d) . In addition, defendants falsely portrayed the Company's growth prospects (¶64),
17 based in part on the premature recognition of revenue as noted above, and also despite the fact that
18 the Company was actually experiencing a decline in demand for products and services and indicated
19 just the opposite to the market (¶64f) . When the true state of Portal's finances and operations began
20 to be revealed, i.e., that the Company would not be able to continue to recognize the amount of
2 1 licensing or services fees it had previously been recognizing or led the market to believe th e
22 Company could recognize in the time periods the Company had led the market to believe it could -
23 the stock dropped 42% in a single day . The announced shortfall was nearly 25% of expected
24 revenues for the 3Q alone - revenues expected based on the Company's previous guidance . As a
25 result of these revelations, and corresponding drop in the price of Portal's stock, investors suffered
26 real economic loss . Further, the timing and magnitude of Portal's stock price decline negates any
27 inference that the loss suffered by Lead Plaintiff and other Class members was caused by changed
28 market conditions, microeconomic or industry factors or Company-specific facts unrelated to th e
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1 Defendants' fraudulent conduct . The economic loss, i.e., damages, suffered by Lead Plaintiff and
2 other members of the Class was a direct result of Defendants' fraudulent scheme to artificially inflate
3 Portal's stock price and the subsequent significant decline in the value of Portal's stock when the
4 true state of the Company's operations and finances were revealed to the market and investors .
5 Portal Software 6 Indexed vs. NASDAQ, S&P Information Technology Index May 20, 2003 to Februaryi 12, 2004 7 $20 9/13103 : Portal 1 1A 3103 Defendants announcethat 8 Total Insider Soles compl et es a secondary Portal expects a net loss of $0.36-$0.40 per share versus prior earning guidance of Shares Sold : 363,125 offerngof$60 million of its common stock. a net profit of $0. 04 per share . 9 Proceeds: $5,045,20 2
10 5120M Defendants announce Portal's finan cial $1 5 resultsfor the first quarter of { fiscal 2004 underthe banner 11 headline : 'Third Consecutive Quarter of Revenue and Business Growth . " 12 0) ~° A 1 13 N ~1 t)S Insiders 4i1h =?t ! a $1 0 r d shares 203500 sha s 14 fir' 111Q346 . for $3 E 52C 8 15 7 <0D3 8119103: Defendants announce 16 Portal's finan ci al results forthe lu '7 P s second quarter offiscal260 4 for 940,346, under the banner headline " Fourth Consecutive Quarter of Revenu e 17 $5 Defendants and Business Growth . Portal Software 613N3. announ ce the format io n of a strategic al li ance 1 8 between Portal an d Microsoft . Sad' IT Index 19 r- - - Class Period : 5120/03 - 11/13103 -,: 20 $0 05/20/2003 06/2612003 08104/2003 09/10/2003 10/16/2003 11121/2003 12/31/2003 02/09/2004 4 2 1 06/0912003 07116/2003 08/2112003 09/29/2003 11/04/2003 12/11/2003 01/21/200 4Q NA.v0 .4w,cvPh (enalbi1 I o0)J1 In4 (d edt Polaismaw M11 tC%pft to 9(003. 22
23 No Safe Harbor
24 141 . The statutory safe harbor provided for forward-looking statements under certain
25 circumstances does not apply to any of the allegedly false statements pleaded in this complaint .
26 Many of the specific statements pleaded herein were not identified as "forward-looking statements"
27 when made. To the extent there were any forward-looking statements, there were no meaningful
28 cautionary statements identifying important factors that could cause actual results to differ materiall y
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1 from those in the purportedly forward-looking statements . Alternatively, to the extent that the
2 statutory safe harbor does apply to any forward-looking statements pleaded herein, defendants are
3 liable for those false forward-looking statements because at the time each of those forward-looking
4 statements was made, the particular speaker knew that the particular forward-looking statement was
5 false, and/or the forward-looking statement was authorized and/or approved by an executive officer
6 of Portal who knew that those statements were false when made .
7 COUNT I
8 Against All Defendants for Violation of Section 11 of the Securities Ac t
9 142. This Count is brought pursuant to Section 11 of the Securities Act, 15 U.S.C. §77k,
10 on behalf of the Class, against all defendants .6
11 143 . On or about September 12, 2003, Portal announced that it had priced a public offerin g
12 I of 4,528,302 shares of its common stock at a price of $13 .25 per share (the "Secondary Offering .")7
13 144. The Secondary Offering shares were registered pursuant to Portal's $50 million shelf
14 registration statement and a related registration statement registering an additional $10 million of
15 Portal's common stock filed with the SEC on or about September 12, 2003 . The registration
16 statement, including a prospectus supplement (the "Registration Statement") was signed by
17 defendants Little, Bain and Patterson, among others . The Registration Statement incorporated by
18 reference Portal's Class Period SEC filings on Form 10-Q, including those set forth above in ¶¶60-
19 63 and 67-70, among others, and included the following representations related to Portal's business
20 and the Company's core product - Infranet :
21 Our real-time, convergent Infranet® platform enables our customers to rapidly define, deploy and bill for services with flexible business 22 models. Intranet, which is our core product, enables the real-time provisioning and reporting of services, including such functions a s 23
24 6 This Count does not contain any allegations sounding in fraud . Moreover, for purposes of this Count, the Pipefitters Plaintiffs affirmatively state that they do not claim that Defendants committed 25 intentional or reckless misconduct or that Defendants acted with scienter or fraudulent intent . 26 Share amounts and prices reflect Portal's 1 :5 reverse split effective September 29, 2003 . Prior to the reverse split, on or about September 13, 2003, Portal issued 22,641,509 shares at a price of $2 .65 27 per share. 28
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1 account creation, user authentication and authorization, activity tracking, pricing and rating, billing and customer service, including 2 self-service, all on a scale of up to millions of users . Service offerings supported by Infranet include wireless services; broadband 3 and Internet services, such as DSL, cable and satellite ; and next generation services, such as unified messaging, gaming and electronic 4 content delivery. Infranet is the foundation for our comprehensive software and services offerings . It is a standard software platform 5 built on an open architecture that can be easily integrated with other business system components . While Infranet is designed to meet the 6 needs of the next generation communications markets and services, it is enhanced with a number of optional modules to provide additional 7 capabilities for specific industry segments, including wireless, wireline, cable, ISP and Internet telephony . We believe that these 8 product-based solutions provide customers with superior total cost of ownership. Our customers range from emerging small companies 9 offering an innovative service to a small number of subscribers to large telecommunications carriers with millions of subscribers . 10 145 . The statements referenced above in ¶144 (including those incorporated by referenc e 11 and set forth above in ¶¶60-63 and 67-70), were each materially false and misleading as they 12 negligently misrepresented and/or omitted the following adverse facts which then existed and 13 disclosure of which was necessary to make the statements made not false and/or misleading, 14 including : 15 (a) that the Company's sales and marketing efforts were not performing well and 16 the Company was experiencing declining demand for its products and services . In particular, 17 according to a former employee of the Company, Portal's customer service applications which prior 18 to the Class Period had been licensed as a part of Portal's billing software, were no longer required 19 by many of Portal's large telecommunications customers . As a result, demand for these applications 20 had materially declined and was unlikely to rebound. Defendants' statements negligently 21 misrepresented the role that Portal's software applications were required to perform within a 22 customer's software infrastructure . For example, prior to the Class period, billing applications like 23 the kind sold by Portal would perform "backend" accounting functions related to a company's 24 accounts receivable, customer care, collections and also taxation . However, new customer 25 relationship management ("CRM") applications from other software vendors have replaced the 26 customer-care function previously provided by Portal's billing applications . Similarly, accounting 27 functions previously handled by Portal's billing applications are now handled by non-billing 28
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1 software applications . Specifically, Siebel and SAP are two software vendors, among others, tha t
2 have displaced the role previously provided by Portal's billing applications for customer service an d
3 accounts receivables, respectively ;
4 (b) that due to continuing and severe problems with the Company's core products ,
5 the Company was unable to service its existing customers, causing additional erosion of the
6 Company's revenue streams . According to a former Portal employee, Portal's software had many
7 problems or deficiencies that made meeting implementation/customization milestones difficult
8 including excessive bugs and/or interface problems with other applications . As a result, Portal was
9 spending too much money on fixing bugs and improving application interfaces causing the
10 Company's costs to rise . The strategy of targeting increasingly larger customers, led the Company
11 to experience more severe problems as Portal's software was "more prone to bugs" as a result of the
12 increased scope of these projects ;
13 (c) that the Company's license revenues were negligently overstated .
14 Specifically , the Company' s structuring of licenses in two parts - developmental and production -
15 allowed Defendants improperly to accelerate the recognition of license fees during the Class Pe riod.
16 Thus, Defendants ' negligent misrepresentations that the Company recognized its licensing revenue
17 upon delivery or using the percentage of completion accounting method (i. e., prior to completion of
18 the project) were materially false and misleading when made. In fact, Portal's reported and
19 projected revenues during the Class Pe riod were materially overstated by millions of dollars due to
20 Defendants ' acceleration of purported license revenues in violation of GAAP and Portal' s
21 contractual obligations. Furthermore, Defendants' premature recognition of Portal licensing revenue
22 violated GAAP because the revenue was recognized prior to delivery of the modified software to
23 Portal's customers . As a result, Portal's Class Period financial statements were materially false and
24 misleading ;
25 (d) that the Company's revenues were further negligently overstated due to th e
26 1 Defendants' manipulation of the purported billable rates of Portal's employees . Specifically, i n
27 connection with contracts performed in foreign countries, Defendants applied inflated billing rate s
28
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1 that improperly permitted Defendants to front load purported contractual costs and thereb y
2 prematurely recognize revenue;
3 (e) that with respect to transactions that included one or more elements to be
4 delivered at a future date, Portal negligently recognized revenue even though Portal manipulated the
5 necessary vendor specific objective evidence of the fair value of all undelivered elements ;
6 (f) that Defendants routinely negligently recognized license and services fees
7 under service arrangements prior to customer approval of specific project milestones in violation of
8 the Company's publicly stated revenue recognition practices and policies . Such improper
9 recognition of revenues artificially inflated the Company's reported and projected revenues during
10 the Class Period and violated GAAP because the revenue was recognized before collectibility wa s
11 treasonably assured ;
12 (g) that the Company's sales and marketing efforts were not performing well and
13 the Company was experiencing declining demand for its products and services ; and
14 (h) that due to continuing and severe problems with the Company's core products,
15 the Company was unable to service its existing customers, causing Portal's costs to rise and
16 additional erosion of the Company's revenue streams .
17 146. The Registration Statements for the Secondary Offering were inaccurate an d
18 misleading, contained and incorporated by reference untrue statements of material facts, omitted to
19 state other facts necessary to make the statements made not misleading, and concealed and faile d
20 adequately to disclose material facts as described above .
21 147. Portal is the registrant for the Secondary Offering . The defendants named herein
22 were responsible for the contents and dissemination of the Registration Statements and th e
23 Prospectus.
24 148. As issuer of the shares, Portal is strictly liable to the Pipefitters Plaintiffs and th e
25 Class for the misstatements and omissions.
26 149. None of the Defendants named herein made a reasonable investigation or possesse d
27 reasonable grounds for the belief that the statements contained in the Registration Statements and th e
28 Prospectus were true and without omissions of any material facts and were not misleading .
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -53- Cade 3 :03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 55 of 6 2
1 150. Defendants issued, caused to be issued and participated in the issuance of materially
2 false and misleading written statements to the investing public which were contained or incorporated
3 by reference in the Prospectus, which misrepresented or failed to disclose, inter alia, the facts set
4 forth above. By reasons of the conduct herein alleged, each defendant violated, and/or controlled a
5 person who violated, Section 11 of the Securities Act.
6 151 . The Pipefitters Plaintiffs acquired Portal shares issued pursuant to, or traceable to ,
7 and in reliance on, the Registration Statements.
8 152 . The Pipefitters Plaintiffs and the Class have sustained damages . The value of Portal
9 shares has declined 42% when the truth began to emerge concerning the Company's adverse
10 financial and business condition concealed by Defendants' misrepresentations, misstatements an d
11 omissions in and incorporated by the Registration Statement .
12 153 . At the times they purchased Portal shares, the Pipefitters Plaintiffs and other members
13 of the Class were without knowledge of the facts concerning the wrongful conduct alleged herei n
14 and could not have reasonably discovered those facts .
15 COUNT II
16 Against All Defendants for Violation of Section 12(a)(2) of the Securities Act
17 154. The Pipe fitters Plaintiffs repeat and reallege the allegations contained in ¶¶143-153 ,
18 above.
19 155. This Count is brought by the Pipefitters Plaintiffs pursuant to § 12(a)(2) of the
20 Securities Act, 15 U.S.C. §771, on behalf of all purchasers of Po rtal shares in connection with, and
21 traceable to, the Secondary Offering. 8
22 156 . Defendants were sellers and offerors and/or solicitors of purchasers of the shares
23 offered pursuant to the Prospectus .
24
25
26 8 This Count does not contain any allegations sounding in fraud . Moreover, for purposes of this Count, the Pipefitters Plaintiffs affirmatively state that they do not claim that Defendants committed 2 7 intentional or reckless misconduct or that Defendants acted with scienter or fraudulent intent . 28
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1 157 . The Prospectus contained untrue statements of material facts, omitted to state other
2 facts necessary to make the statements made not misleading, and concealed and failed to disclos e
3 material facts. The Individual Defendants' actions of solicitation included participating in, and
4 signing, the preparation of the false and misleading Prospectus.
5 158 . Defendants owed to the purchasers of Portal shares, including the Pipefitters
6 Plaintiffs and other class member purchasers of Portal shares, the duty to make a reasonable an d
7 diligent investigation of the statements contained in the Secondary Offering materials, including the
8 Prospectus contained therein, to ensure that such statements were true and that there was no
9 omission to state a material fact required to be stated in order to make the statements contained
10 therein not misleading . Defendants knew of, or in the exercise of reasonable care should have
11 known of, the misstatements and omissions contained in the Secondary Offering materials as set
12 forth above .
13 159. The Pipefitters Plaintiffs and other members of the Class purchased or otherwis e
14 I acquired Portal shares pursuant to and traceable to the defective Prospectus . The Pipefitter s
15 Plaintiffs did not know, or in the exercise of reasonable diligence could not have known, of th e
16 I untruths and omissions contained in the Prospectus .
17 160. The Pipefitters Plaintiffs, individually and representatively, hereby offer to tender t o
18 defendants those securities which the Pipefitters Plaintiffs and other Class members continue to own ,
19 on behalf of all members of the Class who continue to own such securities, in return for th e
20 consideration paid for those securities together with interest thereon . Class members who have sold
21 their Portal shares are entitled to recissory damages .
22 161 . By reason of the conduct alleged herein, these defendants violated, and/or controlled
23 a person who violated, § 12(a)(2) of the Securities Act . Accordingly, the Pipefitters Plaintiffs and
24 members of the Class who hold Portal shares purchased in the Secondary Offering have the right to
25 rescind and recover the consideration paid for their Portal shares and, hereby elect to rescind and
26 tender their Portal shares to the Defendants sued herein . The Pipefitters Plaintiffs and Class
27 members who have sold their Portal shares are entitled to recissory damages .
28
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -55- 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 57 of 6 2
1 COUNT III
2 Against the Individual Defendants for Violation of Section 15 of the Securities Ac t
3 162. The Pipefitters Plaintiffs repeat and reallege the allegations contained in ¶IJ143-161 ,
4 above.
5 163 . This Count is brought pursuant to Section 15 of the Securities Act, 15 U.S.C . §77o,
6 against the Individual Defendants .9
7 164. Each of the Individual Defendants was a control person of Portal by virtue of his/he r
8 position as director and/or senior officer of Portal . The Individual Defendants each had a series of
9 direct and/or indirect business and/or personal relationships with other directors and/or majo r
10 shareholders of Portal .
11 165 . Each of the Individual Defendants was a culpable participant in the violations of § § 11
12 and 12(a)(2) of the Securities Act alleged in Counts I and II above, based on their having signed the
13 Registration Statement and having otherwise participated in the process which allowed the
14 Secondary Offering to be successfully completed .
15 COUNT IV
16 Against All Defendants for Violation of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated Thereunde r 17 166 . Lead Plaintiff repeats and realleges the allegations contained in ¶'j 1-141, above, as i f 18 fully set forth herein . 19 167 . During the Class Period, Defendants carried out a plan, scheme and course of conduct 20 which was intended to and, throughout the Class Period, did : (i) deceive the investing public , 21 including plaintiff and other Class members, as alleged herein ; (ii) enable the Individual Defendants 22 and other Portal insiders to sell more than $5 million worth of their personally-held shares of Porta l 23 common stock at artificially inflated prices; (iii) induced plaintiff and other members of the Class to 24 purchase Portal's securities at artificially inflated prices ; and (iv) proximately cause damages to the 25
26 9 This Count does not contain any allegations sounding in fraud . Moreover, for purposes of this 27 Count, the Pipefitters Plaintiffs affirmatively state that they do not claim that Defendants committed intentional or reckless misconduct or that Defendants acted with scienter or fraudulent intent . 28
CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -56- Cai4e 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 58 of 6 2
1 plaintiffs and the other members of the Class, as the price of Portal's stock declined when
2 Defendants began publicly to reveal the truth concerning the Company's adverse business and
3 financial condition that had been concealed by Defendants' earlier misrepresentations, omissions and
4 other fraudulent conduct.
5 168. In furtherance of this unlawful scheme, plan and course of conduct, defendants, an d
6 each of them, took the actions set forth herein.
7 169. Defendants (a) employed devices, schemes, and artifices to defraud ; (b) made untrue
8 statements of material fact and/or omitted to state material facts necessary to make the statements not
9 misleading ; and (c) engaged in acts, practices, and a course of business which operated as a fraud
10 and deceit upon the purchasers of the Company's securities in an effort to maintain artificially high
11 market prices for Portal's securities in violation of Section 10(b) of the Exchange Act and Rule IOb-
12 5. All defendants are sued either as primary participants in the wrongful and illegal conduct charged
13 herein or as controlling persons as alleged below .
14 170. Defendants, individually and in concert, directly and indirectly, by the use, means or
15 instrumentalities of interstate commerce and/or of the mails, engaged and participated in a
16 continuous course of conduct to conceal adverse material information about the business, operations
17 and future prospects of Portal as specified herein .
18 171 . These defendants employed devices, schemes and artifices to defraud, while i n
19 possession of material adverse non-public information and engaged in acts, practices, and a course of
20 conduct as alleged herein in an effort to assure investors of Portal's value and performance and
21 continued substantial growth, which included the making of, or the participation in the making of,
22 untrue statements of material facts and omitting to state material facts necessary in order to make the
23 statements made about Portal and its business operations and future prospects in the light of the
24 circumstances under which they were made, not misleading, as set forth more particularly herein,
25 and engaged in transactions, practices and a course of business which operated as a fraud and deceit
26 upon the purchasers of Portal securities during the Class Period .
27 172. Each of the Individual Defendants' primary liability, and controlling person liability ,
28 arises from the following facts : (i) the Individual Defendants were high-level executives and/o r
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1 directors at the Company during the Class Period and members of the Company's management team
2 or had control thereof; (ii) each of these defendants, by virtue of his responsibilities and activities as
3 a senior officer and/or director of the Company was privy to and participated in the creation,
4 development and reporting of the Company's internal budgets, plans, projections and/or reports ;
5 (iii) each of these defendants enjoyed significant personal contact and familiarity with the other
6 defendants and was advised of and had access to other members of the Company's management
7 team, internal reports and other data and information about the Company's finances, operations, and
8 sales at all relevant times ; and (iv) each of these defendants was aware of the Company's
9 dissemination of information to the investing public which they knew or recklessly disregarded was
10 materially false and misleading .
11 173 . The defendants had actual knowledge of the misrepresentations and omissions o f
12 material facts set forth herein, or acted with reckless disregard for the truth in that they failed to
13 ascertain and to disclose such facts, even though such facts were available to them . Such
14 defendants' material misrepresentations and/or omissions were done knowingly or recklessly and for
15 the purpose and effect of concealing Portal's operating condition and future business prospects from
16 the investing public and supporting the artificially inflated price of its securities . As demonstrated
17 by defendants' overstatements and misstatements of the Company's business, operations and
18 earnings throughout the Class Period, defendants, if they did not have actual knowledge of the
19 misrepresentations and omissions alleged, were reckless in failing to obtain such knowledge by
20 deliberately refraining from taking those steps necessary to discover whether those statements wer e
2 1 false or misleading .
22 174. As a result of the dissemination of the materially false and misleading informatio n
23 1 and failure to disclose material facts, as set forth above, the market price of Portal's securities was
24 artificially inflated during the Class Period . In ignorance of the fact that market prices of Portal's
25 publicly-traded securities were artificially inflated, and relying directly or indirectly on the false and
26 misleading statements made by defendants, or upon the integrity of the market in which the
27 securities trade, and/or on the absence of material adverse information that was known to or
28 recklessly disregarded by defendants but not disclosed in public statements by defendants during th e
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1 Class Period, plaintiff and the other members of the Class acquired Portal securities during the Class
2 Period at artificially high prices. The price of Portal stock declined significantly when Defendants
3 started to reveal the truth concerning the Company's adverse business and financial condition tha t
4 had been concealed by Defendants' prior misrepresentations, omissions and other fraudulen t
5 conduct.
6 175. At the time of said misrepresentations and omissions , plaintiff and other members of
7 the Class were ignorant of their falsity, and believed them to be true . Had plaintiff and the other
8 members of the Class and the marketplace known the truth regarding the problems that Portal was
9 experiencing, which were not disclosed by defendants, plaintiff and other members of the Clas s
10 would not have purchased or otherwise acquired their Portal securities, or, if they had acquired such
11 securities during the Class Period, they would not have done so at the artificially inflated prices
12 which they paid .
13 176. By virtue of the foregoing, defendants have violated Section 10(b) of the Exchange
14 Act, and Rule I Ob-5 promulgated thereunder .
15 177. Plaintiffs and the members of the Class have been damaged by the decline in Portal' s
16 I stock price near and at the end of the Class Period, which was a direct and proximate result of the .
17 disclosure concerning the Company's adverse business and financial condition that had bee n
18 I concealed by Defendants' prior misrepresentations, omissions and other fraudulent conduct. 19 COUNT V
20 Against the Individual Defendants for Violation of Section 20(a) of the Exchange Ac t
21 178. Lead Plaintiff repeats and realleges the allegations contained in ¶¶1-141 and 166-177 ,
22 above, as if fully set forth herein .
23 179. The Individual Defendants acted as controlling persons of Portal within the meaning
24 of Section 20(a) of the Exchange Act as alleged herein . By virtue of their high-level positions, and
25 their ownership and contractual rights, participation in and/or awareness of the Company's
26 operations and/or intimate knowledge of the false financial statements filed by the Company with the
27 SEC and disseminated to the investing public, the Individual Defendants had the power to influence
28 I and control and did influence and control, directly or indirectly, the decision-making of the
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1 Company, including the content and dissemination of the various statements which plaintiff contend s
2 are false and misleading . The Individual Defendants were provided with or had unlimited access to
3 copies of the Company's reports, press releases, public filings and other statements alleged by
4 plaintiff to be misleading prior to and/or shortly after these statements were issued and had th e
5 ability to prevent the issuance of the statements or cause the statements to be corrected .
6 180 . In particular, each of these defendants had direct and supervisory involvement in the
7 day-to-day operations of the Company and, therefore, is presumed to have had the power to control
8 or influence the particular transactions giving rise to the securities violations as alleged herein, an d
9 exercised the same .
10 181 . As set forth above, Portal and the Individual Defendants each violated Section 10(b )
11 and Rule 1 Ob-5 by their acts and omissions as alleged in this Complaint. By virtue of their position s
12 as controlling persons, the Individual Defendants are liable pursuant to Section 20(a) of the
13 Exchange Act. Plaintiffs and the members of the Class have been damaged by the decline in Portal's
14 stock price near and at the end of the Class Period, which was a direct and proximate result of th e
15 nature and extent of Defendants ' prior misstatements and fraudulent conduct finally being revealed
16 to investors and the market .
17 WHEREFORE, plaintiff prays for relief and judgment, as follows :
18 (a) Determining that this action is a proper class action, designating plaintiff as
19 Lead Plaintiff and certifying plaintiff as a class representative under Rule 23 of the Federal Rules of
20 Civil Procedure and plaintiff's counsel as Lead Counsel ;
21 (b) Awarding compensatory damages in favor of plaintiff and the other Class
22 members against all defendants , jointly and severally, for all damages sustained as a result o f
23 defendants' wrongdoing, in an amount to be proven at trial, including interest thereon;
24 (c) Awarding plaintiff and the Class their reasonable costs and expenses incurred
25 in this action, including counsel fees and expert fees ; and
26 (d) Such other and further relief as the Court may deem just and proper .
27
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11 CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -60- 3:03-cv-05138-VRW Document 111-1 Filed 05/19/2005 Page 62 of 6 2 1
1 JURY TRIAL DEMANDED
2 Plaintiff hereby demands a trial by jury.
3 DATED : May 19, 2005 GREEN WELLING LLP ROBERT S. GREEN 4
5 ROBERT S . GREEN 6 ROBERT S . GREEN ( 136183)
7 235 Pine Street , 15th Floor San Francisco, CA 94104 8 Telephone : 415/477-6700 415/477-6710 (fax) 9 Liaison Counsel for Plaintiffs and the Class 10 LERACH COUGHLIN STOIA GELLER 11 RUDMAN & ROBBINS LL P SAMUEL H. RUDMAN 12 ROBERT M. ROTHMAN RUSSELL J . GUNYAN 13 200 Broadhollow Road, Suite 406 Melville, NY 11747 14 Telephone: 631/367-7100 631/367-1173 (fax) 15 Lead Counsel for Plaintiff and the Class 16
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1 CONSOLIDATED THIRD AMENDED COMPLAINT - C-03-5138-VRW -61-