IN THE UNITED STATES DISTRICT COUR T FOR THE EASTERN DISTRICT OF NORTH CAROLINA WESTERN DIVISION Master File NO.5:04-CV-473 (1 ) FILED
IN RE RED HAT, INC . ) MAY 6 2005 SECURITIES LITIGATION ) CLASS ACTION This Document Relates To: )
ALL ACTIONS )
CONSOLIDATED A MENDED CLASS ACTION COMPLAINT
6 0 TABLE OF CONTENTS
Page 1. NATURE OF THE ACTION ...... 1 II . SUMMARY OF THE ACTION ...... 1 III . JURISDICTION AND VENUE ...... 2 IV . THE PARTIES ...... 3 A. Lead Plaintiffs ...... 3 B. Defendants ...... 3
V. DEFENDANTS' FRAUDULENT SCHEME ...... 6 A. Red Hat's Business Model Allowed Defendants to Conceal Their Fraud ...... 6 B. Defendants' Systematically Engaged in Prematurely Recognizing Revenue ...... 8 (1) Defendants knew most contracts were signed near the end of th e month ...... 9 C. Defendants' Desperation to Recognize Revenue Created a Culture o f Accounting Fraud ...... 10 (1) Red Hat acquires companies just to recognize short term revenue ...... 10 (2) Defendants purposely inflated their subscriber contract renewals ...... 1 1 (3) Defendant Thompson couldn't handle the truth ...... 15 (4) Defendants prematurely recognized revenue on consulting hours ...... 1 6 (5) The Barking Dog : Defendants created an aura of fear and intimidation...... 1 7 (6) Defendants refuse to stop prematurely recognizing revenue eve n after being personally confronted by a high level insider ...... 1 8 D. PWC actively participated in the scheme ...... 21 E. PWC audit staff were intertwined with Red Hat's CFO and Financ e Department...... 22 F. Barber is going to be replaced ...... 24 G. The "firestorm" rapidly approaches ...... 24 H. PWC and the Defendants Know they Are in Imminent Danger of Bein g Exposed...... 26 I. The Individual Defendants Dump Their Stock ...... 26 J . The PWC Replacement Auditor Arrives at Red Hat ...... 27
VI. THE TRUTH REGARDING RED HAT'S REVENUE RECOGNITION SCHEME IS PARTIALLY REVEALED ...... 28 A. Monday, June 14, 2004 -- The CFO Bails Out ...... 28 B. Tuesday, June 15, 2004 - Defendants' Continue to Panic ...... 29 C. Wednesday, June 16, 2004 -- The New Auditor "Drops the Bomb" ...... 30 D. Thursday, June 17, 2004 - Defendants' Announce Earnings Shortfall ...... 30 E. Barber's Tries to Cover His Tracks ...... 32 VII. THE TRUTH REGARDING RED HAT'S REVENUE RECOGNITIO N SCHEME IS FINALLY FULLY REVEALED ...... 33 A. End Of Class Period: Defendants Announce Restatement And SEC Inquiry ...... 3 3
VIII. DEFENDANTS' FALSE AND MISLEADING STATEMENTS ...... 38 A. The Class Period Begins: Defendants Issue False Financial Results For 3Q03 (ended November 30, 2002) ...... 38 B. Reasons for Falsity: 3Q03 ...... C. Defendants Release False Fiscal Year 2003 Year End Financial Results ...... 43 D. Reasons for Falsity: Fiscal Year 2003 (Ended February 28, 2003) ...... 46 E. The Fraud Continues: First Quarter Fiscal Year 2004 (Ended May 31 , 2003) ...... 47 F. Reasons for Falsity: 1 Q04...... 49 G. The Fraud Continues: Defendants Issue False 3Q04 Results ...... 50 H. Reasons for Falsity: 3Q04...... 53 1. Defendants Issue False 4Q04 and Fiscal Year 2004 Results ...... 53 J. Reasons for Falsity: 4Q and FY 2004 ...... 58 K. Red Hat's June 17, 2004 False Statements ...... 59 (1) False statements regarding revenue recognition ...... 59 (2) Defendant Szulik lies about the restatement and SEC investigation ...... 61 L. Reasons for Falsity of the June 17, 2004 Statements ...... 62
IX. DEFENDANT'S OMISSIONS AND FAILURE TO REVEAL THE TRUTH ...... 63
X. DEFENDANTS' FALSE FINANCIAL REPORTING ...... 63 A. Defendants Violated GAAP...... 63 B. Red Hat's Financial Restatement ...... 70 C. Defendants' Additional GAAP Violations ...... 73
XI. PWC'S AUDITING VIOLATIONS ...... 74 A. PWC and Barber's Violations of GAAS ...... 79 B. PWC Violated Section I OA(b)(1) of the Exchange Act ...... 85 C. PWC Violated Its Own Accounting Guidelines ...... 86 D. PWC and Barber Engaged in Improper Professional Conduct Within the Meaning of Commission Rule of Practice 102(e)...... 86 E. PWC's Lack of Independence ...... 88
XII. DEFENDANTS REAPED ENORMOUS FINANCIAL BENEFITS THROUG H THEIR FRAUDULENT SCHEME ...... 90 A. Defendants Acted With Scienter...... 90 B. Defendants' Insider Selling Was Unusual In Timing And Amount ...... 92 C. The Defendants' Compensation, Bonuses, and Other Incentives were Highly Dependent on Meeting Red Hat's Aggressive Financial Objective s and Estimates ...... 96 (1) Defendant Szulik...... 97
ii (2) Defendant Thompson ...... 98 (3) Defendant Buckley...... 99 (4) Defendant Webbink ...... 99 (5) Defendant Cormier...... 100 D. Defendants Were Motivated To Inflate Red Hat Stock In Order To Complete Stock-Based Acquisitions During The Class Period...... 100 E. Defendants Propped Up the Company's Stock Price In Order to Complete a Sale of $600 Million in Convertible Senior Debentures ...... 101 F. Defendant's Had Access to an Enormous Amount of Detailed Financial Information at Their Fingertips ...... 101 (1) Red Hat utilized accounting software ...... 101 (2) Regular internal reports were given directly to management ...... 102 (3) The Finance Department held regular meetings ...... 102 G. The Individual Defendants Controlled All Aspects of Red Hat ...... 102 (1) Defendant Szulik...... 103 (2) Defendant Thompson ...... 103 (3) Defendant Webbink ...... 104 (4) Defendant Buckley...... 104 (5) Defendant Cormier...... 104 H. Defendant PWC Had Significant Financial Incentives to Appease Red Hat ...... 105
XIII. CLASS ACTION ALLEGATIONS ...... 105
XIV. APPLICABILITY OF PRESUMPTION OF RELIANCE: FRAUD ON THE MARKET DOCTRINE ...... 107
COUNTI- VIOLATION OF SECTION 10(B) OF THE EXCHANGE ACT AND RULE 10B 5 PROMULGATED THEREUNDER (AGAINST ALL DEFENDANTS) ...... 109
COUNT II - VIOLATION OF SECTION 20(A) OF THE EXCHANGE ACT (AGAINST SZULIK, THOMPSON, WEBBINK, BUCKLEY AND CORMIER)...... 11 1
COUNT III - VIOLATION OF SECTION 304 OF SARBANES-OXLEY ...... 112
XV. REQUEST FOR RELIEF ...... 11 3
XVI. JURY TRIAL DEMANDED ...... 11 4
iii I. NATURE OF THE ACTION
1 . This securities class action is brought on behalf of purchasers of publicly traded securities of Red Hat, Inc. ("Red Hat" or "the Company") between December 17, 2002 and July
12, 2004 inclusive, (the "Class Period"), seeking to recover damages caused by Defendants' violations of federal securities laws and to pursue remedies under the Securities Exchange Act of
1934 and Section 304 of the Sarbanes-Oxley Act of 2002 .
H. SUMMARY OF THE ACTION
2. In order to falsify Red Hat's financial condition to the investing public,
Defendants, including Red Hat's senior management, and Red Hat's outside audito r
PricewaterhouseCoopers, knowingly and systematically booked revenue before it was actually earned. Under their scheme, which was in direct violation of the rules that govern the accounting profession, SEC rules, and the federal securities laws, Defendants secretly backdated Red Hat's revenue, even though it was not actually earned until later, and then used that backdated revenue to issue false financial reports to Red Hat investors.
3. As is often the case with a lie, the longer Defendants falsely booked revenue, th e harder it became to stop. Increasingly desperate, they devised various techniques to falsely recognize revenue in other ways, all of which have been confirmed by multiple former Red Hat employees. These employees, many of whom had high-level positions or worked inside Red
Hat's finance department, revealed firsthand accounts of Red Hat's multi-faceted scheme, all of which had a single goal - to prematurely recognize revenue .
4. The former Red Hat employees explained how even prior to the Class Period,
Defendants acquired companies in an effort to temporarily boost their short-term revenues . They revealed how Defendants prematurely recognized revenue on consulting work, in blatant violation of accounting rules. They revealed how Red Hat's management intimidated their employees to falsify revenue reports -- or face the consequences. Indeed, at least one high-level
Red Hat employee who dared to confront Defendants about their improper scheme found out quickly what that consequence was - instant termination.
5. In the midst of Defendants' accounting violations and fraudulent revenue recognition scheme, an even darker cloud loomed . Defendants knew that a new outside audit partner had been assigned to Red Hat, and he would soon be arriving on the scene . Unlike the old auditor, he was unlikely to allow, let alone participate, in Defendants' ongoing fraud. So, before they could be caught, Red Hat's executives began dumping their stock onto the unsuspecting market, reaping a mind-bending personal windfall of more than $94 million between the five of them, and shedding huge percentages of their holdings .
6. When the dust finally cleared, Red Hat was forced to revise over three years o f financial information . Red Hat's stock price was devastated, and investors were left holding the bag. Indeed, when the fraud was finally fully revealed, Defendants' lies caused Red Hat's stock to suffer its largest loss ever, plummeting nearly 25% in a single day . All told, from the time the truth began to leak to the market, it took nearly a month for Defendants' fraud to be full y revealed, causing Red Hat's stock to sustain a total of three major blows . By the end of the final day, investors had lost nearly $2 billion of their money, and Red Hat's stock, which had traded at a high of $29.06 during the class period, has never recovered . Nearly a year later it still trades at
only $11 .00 per share.
III. JURISDICTION AND VENUE
7. This Court has jurisdiction over the subject matter of this action pursuant to
Section 27 of the Exchange Act (15 U .S .C. § 78aa) and 28 U.S .C. §1331 . The claims asserted
herein arise under Sections 10(b), 20(a) of the Exchange Act (15 U .S .C. §§ 78j(b), 78t(a)), and
2 the rules and regulations promulgated thereunder by the SEC, including Rule I Ob-5 (17 C .F.R.
§ 240.1 Ob-5); and Section 304 of the Sarbanes-Oxley Act of 2002 (15 U .S.C. § 7243).
8 . Venue is proper in this District pursuant to Section 27 of the Exchange Act and 28
U.S.C. § 1391(b). Many of the acts and transactions giving rise to the violations of law complained of herein, including the preparation and dissemination to the investing public of false and misleading information, occurred in this District . In addition, Red Hat maintains its principal executive offices in this District .
9. In connection with the acts, conduct and other wrongs complained of herein,
Defendants used the means and instrumentalities of interstate commerce, including the mails, telephone communications and the facilities of national securities exchanges .
IV. THE PARTIES
A. Lead Plaintiffs
10. The Union Group ("Lead Plaintiffs"), consisting of United Food and Commercia l
Worker's Local 1262 and Employers Pension Fund ("UFCW Local 1262"), the Zhang Family
(Yile Zhuang and Zhijie Zhuang), Robert Piccurrio, Steve Salek and Eric Bushman, were appointed Lead Plaintiffs on January 13, 2005 . Lead Plaintiffs purchased Red Hat common stock and have suffered losses for the reasons stated in this Complaint .
B. Defendants
Red Hat, Ina
11 . Defendant Red Hat, Inc. ("Red Hat") is a Delaware corporation with its principal
offices at 1801 Varsity Drive, Raleigh, North Carolina 27606. The relevant background and
details of Red Hat 's business is contained in Section V.A. of this Complaint. Red Hat ' s fiscal
year begins on March 1 of each year, and ends on February 28 ofthe following year. For
example, March 1, 2003 to February 28, 2004 is Red Hat's fiscal year 2004 (FY `04), and the
3 fiscal quarterly periods contained within FY '04 are March 1, 2003 to May 31, 2003 (1Q '04),
June 1 , 2003 to August 31, 2003 (2Q '04), September 1, 2003 to November 30, 2003 (3Q '04), and December 1, 2003 to February 28, 2004 (4Q '04) .
Matthew J. Szulik
12. Defendant Matthew J. Szulik has been Red Hat's Chief Executive Officer since
November of 1999, was elected Chairman of the Board of Directors in Apri l of 2002, served as
President since November of 1998 and as a director since April of 1999 . Defendant Szulik also served as Chief Operating Officer from November of 1998 to April of 1999 . Defendant Szulik signed Red Hat's Forms 10-K for fiscal years ending February 28, 2003 and February 29, 2004, in addition to all Forms 10-Q for those fiscal years. Defendant Szulik also certified Forms 10-K for fiscal years ended February 28, 2003 and February 29, 2004, in addition to Forms 10-Q for the fiscal quarters ending August 31, 2002, November 30, 2002, and May 31, 2003 . In addition,
Defendant Szulik participated in several conference calls with analysts throughout the Class
Period, including calls on December 17, 2002, March 25, 2003, June 17, 2003, September 18,
2003, December 18, 2003, March 23, 2004 and June 17, 2004.
Kevin B. Thompson
13. Defendant Kevin B . Thompson is a certified public accountant and served as
Executive Vice President of Red Hat from February of 2001 and Chief Financial Officer fro m
November of 2000, until he resigned on June 14, 2004 and subsequently left sometime in
September of 2004 when the new CFO, Charles Peters, Jr ., took over. Defendant Thompson also served as Senior Vice President of Red Hat from November of 2000 to February of 2001, and
Vice President of Operations from September of 2000 to November of 2000 . Prior to joining
Red Hat, Defendant Thompson was a Technology Partner with PricewaterhouseCoopers, LL P
4 from June of 2000 until September of 2000, having joined the accounting firm in January of
1998. Prior to this, Defendant Thompson was a Senior Manager with the accounting firm of
Andersen, LLP, formerly known as Arthur Andersen . Defendant Thompson signed Red Hat's
Forms 10-K for fiscal years ending February 28, 2003 and February 29, 2004, in addition to al l
Forms 10-Q of those fiscal years . Defendant Thompson also certified Forms 10-K for fiscal
years ended February 28, 2003 and February 29, 2004, in addition to Forms 10-Q for the fiscal
quarters ending August 31, 2002, November 30, 2002, and May 31, 2003 . In addition,
Defendant Thompson participated in several conference calls with analysts during the Class
Period, including calls on December 17, 2002, March 25, 2003, June 17, 2003, September 18,
2003, December 18, 2003, and March 23, 2004.
Mark H. Webbink
14. Defendant Mark H . Webbink has served as General Counsel of Red Hat since
May of 2000, Secretary since July of 2000, Senior Vice President since February of 2001, and
Deputy General Counsel for intellectual p roperty and public policy since June of 2004 . Prior to
joining Red Hat, Defendant Webbink practiced licensing, intellectual property transactions,
general corporate law and trademarks at the law firm Moore & Van Allen, PLLC, where he
represented numerous technology companies . Defendant Webbink participated in a June 17,
2003 conference call with an alysts.
Timothy J. Buckley
15 . Defendant Timothy J . Buckley served as Executive Vice President since February
of 2001, Chief Operating Officer since April of 1999, until his retirement in December of 2003.
Defendant Buckley also served as Senior Vice President from April of 1999 to February of 2001 .
Prior to joining Red Hat , from October of 1997 until April of 1999, Defendant Buckley was
5 Senior Vice President of Worldwide Sales at Visio Corp., a business software company .
Defendant Buckley participated in several conference calls with analysts throughout the Clas s
Period, including calls on December 17, 2002, March 25, 2003, June 17, 2003 , and September
18, 2003.
Paul J. Cormier
16. Defendant Paul J. Cormier has served as Red Hat's Executive Vice President o f
Engineering since May 2001 . Prior to joining Red Hat, from March of 1999 to May of 2001 ,
Defendant Cormier served as Senior Vice President, Research and Development at BindView
Development Corporation, a network management software company .
PricewaterhouseCoopers LLP
17. Defendant PricewaterhouseCoopers LLP ("PWC") is a limited liability
partnership of certified public accountants, auditors and consultants that provides audit and
assurance services, advisory services and tax and human resource services . It maintains its
headquarters at 300 Madison Avenue, New York, NY 10017 . Defendant PWC served as Red
Hat's auditor and principal accounting firm throughout the Class Period.
References to Red Hat Management Defendants
18. Defendants Szulik, Thompson, Webbink, Buckley, and Connier are collectivel y
referred to in this Complaint as the "Individual Defendants ."
V. DEFENDANTS' FRAUDULENT SCHE ME
A. Red Hat's Business Model Allowed Defendants to Conceal Their Frau d
19. Red Hat is one of the largest companies in the world that is dedicated to ope n
source software . Basically, open source software represents a shift in how computer software is
created. Unlike most proprietary software (such as Microsoft's Windows), the code that make s
6 up open source software is available to anyone free of charge, and developers who use the software are allowed to freely make improvements to it .
. 20. One of the most recognized open source software programs ever created is called
Linux. Like Microsoft Windows, Linux is a computer operating system . An operating system is a software program that enables the computer hardware to communicate and operate with the computer software . Without an operating system, a computer would be useless . Originally developed by a Finnish student named Linus Torvalds in 1991 for free distribution to all, Red
Hat used Linux to create its own variant so it could profit from the free program . Red Hat began
selling their version of the Linux, which they called Red Hat Linux, in 1994 .
21 . Today, Red Hat sells one of the most recognized Linux brands available, Re d
Hat's Enterprise Linux. Like the original Linux, this program is also an operating system .
However, Enterprise Linux is designed for larger users such as businesses, academic institutions,
and government entities to operate multiple computers on a single network (similar to
Microsoft's Windows 2000) . Red Hat also markets what it calls the Red Hat Enterprise
Network, which is a system that makes updates, patches, and bug fixes available to users of Red
Hat Linux and Red Hat Enterprise Linux .
22. Red Hat sells Enterprise Linux and the Red Hat Enterprise Network through what
it calls a subscription model . This simply means that these technologies and services are sold in
the form of annual subscriptions on a per-computer basis (generally meaning the more computers
a customer is operating, the more subscriptions it will need to purchase).
23. When Red Hat sells a subscription agreement, it receives revenue, which as a
public company it is required to report to investors pursuant to the federal securities laws . These
laws, as well as accounting regulations, sensibly require that a company may not tell investor s
7 (who have no access to the company's internal books, records, or subscription agreements) it has
earned revenue until that revenue has actually been earned .
24. Red Hat purposely decided to ignore these rules, and with the help of its auditor
PriceWaterhouseCoopers, it booked millions of dollars of revenue before it was actually earned,
thus lying to investors and issuing false financial reports in violation of the federal securities law .
Red Hat was able to accomplish its premature revenue recognition scheme by setting up a system
whereby it shifted revenue it earned at the end of the month to the beginning of the month . Of
course, this only worked until they were caught, and when they were, it had a devastating effect
on Red Hat's stock price and on investors who rightfully expected Red Hat's management to tell
the truth about its financial condition .
B. Defendants ' Systematically Engaged in Prematurely Recognizing Revenue
25. The Former Treasurer' explained how Defendants' scheme worked . If Red Hat
received a signed contract to provide a customer with certain services on May 31, and if it was a
one year contract (as the majority of them were), 1/12th of the revenue associated with that
contract would be recorded by Red Hat in May on that day even though Red Hat had not
provided any services to the customer for that month.
26. Another example would be when a Red Hat customer purchased a subscription t o
Linux Enterprise on August 28, rather than Red Hat recognizing 4 days of revenue (August 28-
31), the Company would instead improperly book 31 days of revenue as if it had been earned on
August 1 . Since Red Hat's second fiscal quarter ends on August 31, this had the effect o f
prematurely recognizing the quarterly revenue that was reported to investors . When thousands
1 To protect their identity, all former Red Hat employees are referred to in the masculine regardless of their actual gender. In addition, all witnesses described in this Complaint identified as "Former" are former employees of Defendant Red Hat unless otherwise noted .
8 of sales are booked this way, as they were at Red Hat, this had the effect of shifting large amounts of revenue into prior quarters (and years), so when Red Hat told investors how much revenue it earned in a particular financial period, that amount was false .
27. As former Red Hat employees have confirmed, Defendants knew what they were doing was wrong. For example, the Former Director of Professional Services confirmed that there was no reason for this scheme other than a desire to accelerate revenues that Red Hat should have been recognizing on a monthly versus a daily basis . He said that Red Hat's revenues and costs were generally fixed, the contracts were in place, and it would not have been any more expensive for the Company to have "pushed a button" and thereby tallied the accounting figures on a daily basis as opposed to a monthly basis .
28 . Indeed, he confirmed that all that was necessary in order for Red Hat to determin e where it stood from an accounting and financial standpoint on a daily basis was to input the
quantifications of a transaction within a standard Excel spreadsheet . In terms of the actual
accounting figures, he said all that would have changed was the divisor, meaning that the incom e
less the costs would have been divided by 365, instead of 12 . He explained that it would not
have been any more time consuming or cost prohibitive to calculate the numbers on a daily
versus a monthly basis.
(1) Defendants knew most contracts were signed near the end of the month
29. Defendants orchestrated the premature revenue recognition scheme because the y
knew that many of their sales were made at the end of the month (and hence at the end of the
quarter and year end). The Former Director of Professional Services confirmed that the "real
reason" the Company recognized revenues on a monthly basis was "clear" -- they wanted to be
able to recognize a full month of revenue for contracts that were signed on or towards the end of
9 the month, as many contracts were. Another former Red Hat employee, the Former Treasurer, corroborated this, stating that a significant quantity of Red Hat's contracts were signed towards the end of any given month .
30. The Former Managing Consultant/Director of Professional Services2 also confirmed that it was very, very common for Red Hat to experience a large "spike" in business during the last month of each Quarter. The Former Director of Business Intelligence recalled that the pressure exerted upon Red Hat's upper management to achieve the Company's financial objectives intensified significantly at the end of every quarter .
C. Defendants ' Desperation to Recognize Revenue Created a Culture of Accounting Fraud
(1) Red Hat acquires companies just to recognize short term revenue
31 . Company insiders have revealed that Defendants, even before the Class Period began, did whatever they could to artificially boost short term revenues, as well as to disguise the problems they were experiencing in generating revenue. One way they accomplished this was by acquiring other companies just to recognize their revenue stream .
32. The Former Director of Professional Services explained that Red Hat acquire d other businesses with the "100% purpose" of assuming the revenues of the acquired companies
in order to smooth over dips in income experienced by Red Hat . By doing this, he said, Red
Hat's shareholders were appeased with a one-time injection of revenue. He said that after
enjoying the one-time revenue infusions from the acquired companies, the acquired companies
were then left to "die on the vine ." The Former Regional Account Manager also confirmed
Defendants' improper acquisition strategy, saying the company's management was onl y
2 The Former Managing Consultant/Director of Professional Services and The Former Director of Professional Services are two different witnesses.
10 interested in realizing short term revenues in order to drive up the stock price as high as possible in the fastest time frame possible.
33. In the meantime, Red Hat's management did not tell investors the real reason behind these acquisitions, which was to simply boost short term revenue. In addition, the truth was that nearly all the acquisitions had been complete failures . The Former Financial Analyst in the Accounting Department spoke directly with Defendant Szulik around June or July 2004 about Red Hat's history of what he considered unsuccessful acquisitions . Defendant Szulik told the Analyst "point blank" that Red Hat had completed 16 acquisitions, and that he considered 15 of these acquisitions to have been "total failures ."
34. Other high-level former insiders corroborate both the content of Defendan t
Szulik's private admission, and Red Hat's improper acquisition strategy. The Former Regional
Account Manager confirmed that "every" acquisition that the Company made was a total failure.
In addition, the Former Managing Consultant/Director of Professional Services heard it said many times during his Red Hat employment that Red Hat would buy companies solely for the purpose of acquiring the companies' revenue streams . He also claimed that it was Red Hat's intention to provide itself a temporary "injection" of money to cover shortfalls of revenue .
Finally, he confirmed that after assuming the acquired companies' revenue streams, Red Hat thereafter allowed the companies to "wither away ."
(2) Defendants purposely inflated their subscriber contract renewals
35 . During the Class Period, Defendants also knowingly inflated the percentage o f customers who were going to renew their subscriptions. This is an important metric that outside analysts and investors look to, because as the Former Director of Business Intelligence explained, a company will find itself in a compromised situation when it has prematurely recognized at least some of the revenue in association with its subscriptions, and the customer s
I1 then fail to renew . The Former Director of Business Intelligence also said that it was imperative that Red Hat have consistently high renewal rates in order to keep the Company's business in line with projections, and, as such, Red Hat's renewal rates were paramount to the Company's financial well being .
36. But as Defendants became increasingly desperate as time went on, they chose to falsify their accounting, lie to investors, and withhold the truth regarding the true nature of the
Company's finances, including the actual number of subscription renewals . Numerous high- level former insiders confirmed that Defendants were basing their reports on false numbers because, as the Former Financial Analyst in the Accounting Department put it, Red Hat's executives, including Defendant Szulik, were becoming increasingly afraid of being unable to keep the projections close to actual results because the market was consistently expecting the company to deliver growth quarter after quarter, year after year . The Former Managing
Consultant/Director of Professional Services said that Red Hat's attempt to "sell stuff that we couldn't deliver" created the shortfall.
37. The Former Managing Consultant/Director of Professional Services bluntl y explained how it is a well known fact that within any sales organization, there will always be sales staff who "are going to come in and blow smoke ." He stated that because it was well known that the Red Hat executives never wanted to receive or acknowledge bad news, the submission of highly inflated sales forecasts was relatively a well known problem at Red Hat .
No one at Red Hat either reviewed or reduced the forecasts in order to make them more realistic, nor was any verification of the forecasting numbers conducted .
38. The Former Managing Consultant/Director of Professional Services also explained that "normal companies" hold regular forecasting meetings in which the pipelin e
12 forecasts are reviewed with the sales staff. Typically, management will hold the "feet [of the sales reps] to the fire" to determine the true prospects for particular deals. He said that the managers leave these meetings with an adjusted, but much more realistic , sales forecast, which is then disseminated to the public and the SEC. However, he claimed these kinds of in-depth and critical forecasting meetings were not done at Red Hat .
39. The Former Regional Account Manager corroborated this, and presented an even more detailed account of Defendant's forecasting activities . He confirmed that there was a very significant difference between the Company's internal forecasts regarding subscriber contract renewal rates and those that were reported to the public. According to this witness, the forecasted renewals reported to the public were "much higher" than the actual/internal subscriber contract renewal forecasts . He stated that Red Hat's publicly reported subscriber contract renewal rates were comprised of "lies" and "bullshit" which were intended to make the Company
"look good to Wall Street."
40. The Regional Account Manager explained that one duty of the sales personne l was to provide forecasts of which existing customers they expected to renew their subscriptions with Red Hat. These subscription renewal forecasts were ultimately consolidated and forwarded to the CFO, who then used them as supposedly the basis for what Red Hat publicly stated were the company's anticipated renewal rates . However, the witness asserted that Red Hat's publicly reported forecasts were never actually attained at any time during his tenure . He recalled that throughout his tenure at the Company, Red Hat reported forecasted subscriber contract renewal rates well over 75%, when, in reality, the actual subscriber contract renewal rates never exceeded
50%.
13 41. The Regional Account Manager said that the sales staff were well aware that their subscriber contract renewal forecasts were going to be submitted directly to the CFO, and that it was known that these forecasts had a direct effect upon how these individuals were perceived by upper management. The members of Red Hat's sales staff who submitted accurate, but therefore lower, subscriber contract renewal forecasts were not well regarded, were actively chastised by management, including Alex Sanchez, Vice President of Sales, and accused of having poor or deficient sales skills. The witness stated that although the subscriber contract renewal forecasts were not verified or validated (nor was there any consequence imposed upon the sales staff for submitting inaccurately high subscriber contract renewal forecasts), the ramifications for submitting accurate and therefore lower subscriber contract renewal forecast percentages were significant.
42. He recalled that whenever a Red Hat sales representative made the mistake of being too accurate and included too many "no's" (i .e., customers who indicated that they did not intend to renew their Red Hat subscriber contracts) within a subscription renewal forecast, the sales representative would invariably receive a "visit" from the sales manager reminding him/her that these forecasts were submitted directly to Defendant Thompson. The sales rep would typically be asked something like, "are you really sure" about the given forecast results .
However, the sales reps never received visits of this nature when very high subscription contract renewal forecasts were submitted, even after those forecasts proved to have been overstated. As a result, Red Hat's inside sales staff, as a matter of course, positively skewed their subscriber contract renewal forecasts .
43. The witness remembered that one of the ways by which the Company's sales staff achieved artificially high subscriber contract renewal forecasts was by only contacting customer s
14 that they were relatively certain were going to renew. The witness reiterated that Red Hat did nothing to confirm and/or verify that the sales staff was contacting a representative sample of their customers, much less verify whether the reported renewal forecasts were based on representations about anticipated contract renewals actually made by the customers to the Red
Hat sales staff. These forecasts from the sales reps were put into Excel spreadsheets, which included information as to whether the customer was expected to renew, and if not, why not, and if so, the dollar value of anticipated revenue associated with the given contract renewal . The witness indicated that the subscription contract renewal forecasts were combined, or rolled up by the sales managers, who thereafter submitted the rolled up reports to the CFO.
(3) Defendant Thompson couldn't handle the truth
44. Red Hat's CFO, Defendant Kevin Thompson, also knowingly assisted i n disseminating false subscription information to investors. According to the Former Director of
Professional Services, anyone within the Company, himself included, who had the audacity to present Defendant Thompson with any "bad news," especially about unfavorable sales o r revenue numbers, risked immediate termination. Even those who attempted to address the idea of incorporating a "normalizing force" to establish a more reliable revenue and /or contract renewal target for Red Hat were met with severe disapproval by Red Hat Director of Operations
Mandeep Chaddha, Red Hat Senior Director of Operations Tim Lucas, and/or Defendant
Thompson .
45 . As the Former Director of Professional Services put it, "[Defendant] Thompson couldn't handle the truth ." The witness added that Red Hat's sales projections were also exaggerated because if members of Red Hat's sales team did not have what was internally referenced as a "full pipe," and if the sales staff wished to remain employed, the sales personnel resorted to pulling their weekly sales figures out "of their asses" in order to appease Defendan t
15 Thompson. The Former Director of Professional Services stated that he knew, without any doubt, that sales staff who did not produce the rosy sales forecasts that Defendant Thompson demanded were "out of a job, on the spot," and this, he said, was a reality he witnessed, not a rumor he heard, as "I ran the team, I know what happened ."
(4) Defendants prematurely recognized revenue on consulting hours
46. Consistent with their pattern of premature revenue recognition and imprope r accounting, Defendants also engaged in revenue recognition manipulations with respect to the consulting services that Red Hat offered to its customers . The Former Director of Professional
Services confirmed that Defendants were recognizing a large quantity of revenues in association with consulting hours that had not actually been worked . He explained that in association with its billable consulting hours, Red Hat had a "nasty habit" of billing the customer, in this case,
Lawrence Livermore National Laboratory (LLNL) (which the witness described as a multi- million dollar Red Hat account) many, many more consulting hours than had actually been worked, for the purpose of pulling future revenues into current quarters to ensure that the
Company made its revenue targets for that current period.
47. Referring to Defendants' practice as "selling out his next quarter," he said that the primary problem with pulling revenues back from future quarters, in addition to the fact that it was unethical, is that once the future time periods are reached, the manager in charge of the consultants is "stuck" with a "bunch of work" for the consultants to do and no budget with which to compensate the consultants, as the associated revenues had been realized prematurely by Red
Hat. Another Former Director of Professional Services also confirmed that this was akin to going "into the next quarter with nothing. . .no billable revenue," as it had already been prematurely recognized .
16 (5) The Barking Dog: Defendants created an aura of fear and intimidation
48. In order to artificially achieve short term revenue goals, and to keep the stock price inflated, the standard method of operation by the Individual Defendants was to maintain an
atmosphere of fear and intimidation among Red Hat's staff and employees . This directly
contributed to the improper activities described in this Complaint, such as the premature revenu e
recognition, and the false sales forecasts handed in by the sales staff. One "wrong move" at Red
Hat, which could include submitting low (yet accurate) renewal forecasts, questioning
management's revenue recognition policies, or even reporting accounting fraud, would be met
with swift and strong retribution from the Individual Defendants who controlled Red Hat .
49. For example, the Former Regional Account Manager stated the Company' s
excessively high employee turn-over rates were due, at least in part, to the fact that Defendant
Szulik frequently threatened to fire people over relatively minor issues, often during large,
office-wide meetings . Another former employee, the Former Financial Analyst in the
Accounting Department said that Defendant Szulik could be very abrasive, and likened him to a
"barking dog." The witness said that when Defendant Szulik wanted "the numbers" on his desk,
he wanted them "NOW!" He also said that Defendant Szulik put the "fear of God" into
everyone who worked for Red Hat. The Former Director of Professional Services also stated
that Defendant Szulik often "barked" at people during meetings, and intimated, if not openly
stated, that he intended to terminate certain individuals .
50. The Former Inside Account Executive also recalled that during large employee
meetings, Defendant Szulik would threaten employees by saying "You'd better do this or you're
fired," which created an environment of hostility and intimidation within the Company . The
Former Project Manager & Senior Business Analyst characterized the Red Hat work
17 environment as hostile, and he said that everyone was always "walking on glass," afraid of being terminated. Finally, the Former Managing Consultant/Director of Professional Services said that
Red Hat's executive staff did not want to "hear bad news, ever." The witness explained that if anyone questioned anything Defendants Szulik and/or Thompson did in any way, "that person disappeared, fast."
(6) Defendants refuse to stop prematurely recognizing revenue even after being personally confronted by a high level inside r
51 . Defendants knew the proper methods and controls they should have implemented, and were even personally told by high-level employees that they needed to stop their current improper activity. However, instead of changing their ways, the Individual Defendants met any challenge with responses that ranged from indignation (at the least) to immediate termination of any employee (no matter what level) who either refused to participate, or dared to challenge their fraudulent methods .
52. The Former Managing Consultant/Director of Professional Services explaine d how consulting revenue is normally recognized. He said that when a consulting company enters into a new consulting contract, the company is supposed to conduct a detailed assessment of the consulting project in order to develop a Statement of Work, or "SOW," which basically contains a breakdown of what the company is going to do, what the company is going to deliver, and the date of delivery. He stated that stages of this plan become "milestones," or points of delivery, and, once the points of delivery are reached, the consulting company can bill against the contract total and recognize a certain portion of the revenue associated with the consulting contract .
53. He recalled that other consulting companies typically utilize MS Project 4 or a similar spreadsheet program in order to track the achievement of milestones . The witness explained that he was well versed in the conduct of these kinds of project assessments and i n
18 determining the appropriate milestone plan . However, Red Hat's executive management consistently would "not agree" to implement this measure of control over the projects or revenue recognition process. Instead, the Red Hat executive management staff informed him that "you can't do it that way, that's not the way we do it here [at Red Hat] ."
54. The situation was even more severe for the Former Director of Professiona l
Services, who explained that because he knew his head was going to be on the chopping block in either the previous quarter (if he failed to go along with the Company's program of stealing revenue from future quarters) or in the following quarter (for being unable to achieve revenue targets as explained), he figured that he had "nothing to lose" by confronting Red Hat Director of
Operations Mandeep Chaddha and Senior Director of Operations Tim Lucas about his objections in writing.
55 . So, in October 2002, he began a process of confronting the "higher ups," to whom he directly and/or indirectly reported, including Chaddha and Lucas, with regard to the means and manner in which Red Hat had been recognizing revenue . He wrote an email (the subject line of which read "LLNL billing number vs . recognize number + actual hours worked") asking
Chaddha to explain the logic behind the revenue recognition number he calculated in association with two projects called DMX and Chromium . In essence, the email pointed out that in the following quarter, he was expected to execute $780,000 of work, but "show no revenue," as it had all already been recognized in the previous quarter .
56. In response, Chaddha wrote that "we can perhaps recognize only 200K in the current quarter ." The Former Director of Professional Services responded to Chaddha saying "I don't know what kind of math or logic constitute the `perhaps 200k' you are speaking of," "you have not yet explained the logic behind your revenue recognition number? Is there any?", and " I
19 do not want some arbitrary recognition number to be some kind of indicator of resource s required."
57. Chaddha responded "I believe we have already had the discussion about th e
LLNL revenue recognition numbers." Again, the Former Director of Professional Service s attempted to get Red Hat management to listen, saying "I am reporting what I will be billing,
[but] you are telling me I can't report that," "I do not know what to report because the logi c behind our revenue recognition policy has never been explained," and "[w]hat is the rational e behind the 'perhaps 200K ' That does not sound like it comes from the GAAP binder."
58. However, his follow-up e-mails fell on deaf ears. The former Red Hat employee stated that the bottom line was that Red Hat was allotting "many, many" more man hours a s having been already worked, at least in association with the LLNL account, in order to accelerate the revenue associated with the LLNL projects, but the work still needed to be done in order to complete the project.
59. After sending his email, the former Red Hat employee confronted Red Hat's Vic e
President of Operations Tony Moretto with the same information . When he did, Moretto attempted to intimidate him by threatening his continued employment with Red Hat if he did no t keep quiet, telling him that if he "couldn't handle it," he would "lose his job ."
60. The former Red Hat employee responded to Moretto's threats by stating that when he was not able to achieve revenue goals in future quarters because the Company had already prematurely recognized all of the associated revenues in previous quarters, he probably would not be looking at a very bright future at Red Hat at that point either . To this, Moretto did not offer any response . However, soon thereafter the former Red Hat employee's internal employee rating previously allocated to him by Red Hat's employees (and which had ranked him
20 in the top 10% of Red Hat employees) was lowered. Morretto had "re-ranked " him down to the
50th percentile .
61 . That same month , still having convinced no one in Red Hat m anagement that they must stop recognizing revenue prematurely, the Former Director of Professional Services met in person with Defendant Thompson to discuss his concerns that Red Hat had been prematurely
recognizing consulting revenue associated with the LLNL project. The former Red Hat employee said he "sat down" in Defendant Thompson's office and confronted Defendant
Thompson with the fact that he was being put in the position to report numbers in association with work that had not yet been completed, and he wanted an explanation from Defendant
Thompson as to how he could possibly be expected to go along with this, when he was clearly not going to be able to achieve his revenue goals in future quarters since revenue was being prematurely recognized.
62. The Former Director of Professional Services said Defendant Thompso n dismissed his concerns about the premature revenue recognition, telling him "you don't have to worry about next quarter. . .I'll take care of you .-This is what we have got to do." The former employee recalled that the implication of Defendant Thompson's statements to him was "go along with it, don't make noise" and he would not have any problems . Shortly thereafter,
Defendant Thompson escorted the former employee out of his office with a smile and a pat on the back. Almost immediately after this meeting, the Former Director of Professional Services received word that his employment with Red Hat had been terminated .
D. PWC actively Participated in the scheme
63. PWC actively assisted and participated, both directly and knowingly, in Red Hat's ongoing revenue recognition fraud. As detailed below, Red Hat's chief audit partner from PWC directly assisted Red Hat in its plan, knew what he was doing was wrong and in violation of th e
21 rules governing accounting, and even tried to cover up the fraud when his active participation was exposed.
E. PWC audit staff were intertwined with Red Hat 's CFO and Finance Department
64. PWC has been Red Hat's auditor during Red Hat 's entire existence as a public company (since Red Hat's IPO on August 11, 1999). This is further confirmed by the Former
Treasurer, who said that PWC initially entered into the Red Hat engagement even prior to the
IPO, beginning in 1998 . Both the Treasurer and the Former Senior Staff Accountant revealed that for the five year period prior to the restatement , a PWC Audit Partner named Jeff Barber had been the PWC Audit Engagement Partner assigned to the Red Hat account .
65. The Treasurer also revealed that Barber and Red Hat's CFO, Defendant
Thompson, had previously worked together at PWC, as did several other individuals who worked closely with Defendant Thompson at Red Hat . The Former Director of Business
Intelligence said that prior to Defend ant Thompson's tenure as Red Hat's CFO, Defendant
Thompson worked for PWC. This was further confirmed by the Former Senior Staff
Accountant, who stated that Red Hat 's accounting department employed "a lot of people" who were formerly employed by PWC, and as a result, there was "a lot" of PWC accounting literature to be found within the Red Hat Corporate Office accounting department . He reiterated that
Defendant Thompson had been employed by PWC for "a while" before he became Red Hat's
CFO, and that in addition to Defendant Thompson, Senior Vice President of Revenue
Recognition William Tendel , as well as current Senior Finance Manager Bart Kalsu and Jason
Savod, both of whom repo rted to Defendant Thompson, were also previously employed by
PWC.
22 66. The Former Treasurer said that it was well known within Red Hat that Defendant
Thompson used to work at PWC's Raleigh office, and that Barber was Defendant Thompson's boss throughout his tenure at PWC . He said that Barber "runs" the Raleigh PWC office, and, that all of the PWC employees who work out of Raleigh technically report to Barber. He said that while Defendant Thompson was working at PWC, Defendant Thompson brought Red Hat in as a client .
67. The Former Financial Analyst in the Accounting Department stated that PW C
"pretty much always had bodies" at Red Hat . This made sense, as the Former Treasurer explained that Red Hat did not have any internal audit staff whatsoever . The Former Financial
Analyst in the Accounting Department said that these PWC personnel were typically involved in conducting some form of auditing function within the Red Hat premises, and that Defendant
Thompson and Senior Finance Manager Bart Kalsu both interacted with the PWC auditors on a regular basis. A Former Senior Staff Accountant indicated that Red Hat had worked with the same PWC audit staff for many years prior to June 2004, and that during his Red Hat employment, he worked closely with three or four Red Hat employees who had previously been
employed by PWC .
68. The Treasurer also confirmed that the PWC auditors were usually working on
"one thing or another" at the Red Hat Corporate Office. He explained that because Red Hat is a
publicly-traded Company, and is required to file a quarterly lOQ and earnings release, PWC was
required to be at the Red Hat premises on at least a quarterly basis to do the necessary audit
review. In the course of a typical year, he said that PWC conducted auditing work at the Red
Hat premises at least 5 times a year, and on each occasion, they were never at the Red Hat
premises for less than one week, and were usually there longer . He recalled that during the year
23 end audits, when there was more work to be done, PWC auditors were on the Red Hat site for approximately two weeks .
69. The Treasurer said that after every Red Hat annual audit was completed, PWC met with Red Hat's Board of Directors and Audit Committee, usually in March or April, in order to inform them of the results of the audit and the auditors associated opinion . Many of the attendees participated by telephone . He said that Barber and his staff led the discussion on these calls, and that Defendant Thompson also participated in these conference calls . He also said that
PWC had a hard copy format of these presentations, and that Defendant Thompson and the Red
Hat Audit Committee would have received a copy of this .
F. Barber is going to be replaced
70. In July 2002, which was then approximately three years into Barber's tenure a t
Red Hat, the Sarbanes-Oxley Act was enacted. As part of the new Act, and in recognition of the paramount importance of having an independent auditor, Congress required that no accounting firm could have an lead auditor responsible for a particular company for longer than five years .
See Sarbanes-Oxley Act of 2002, Pub . L. No.107-204, Title II, § 203, 116 Stat. 772 (2002), codified at 15 U .S.C. 78j-1(j).
71 . In Red Hat's case, PWC was now required to replace Barber with a new audit partner beginning in the first quarter of Red Hat's fiscal 2005, which would begin on March 1,
2004 and end on June 1, 2004. Indeed, the Former Director of Business Intelligence confirmed
that the auditor rotation would be the factor that precipitated the "shit hitting the fan" in terms of
Red Hat's earnings restatements .
G. The "firestorm" rapidly approaches
72. Barber and the Defendants were growing increasingly tense and uneasy as the
auditor rotation approached, because they knew that the new auditor would not be entrenched
24 with management, and therefore would likely not continue to go along with the premature revenue recognition scheme . Even worse, they knew that the new auditor would probably discover the scheme on his own, thus forcing Defendants to reveal their lies and omissions, restate the comp any's financials, and generally triggering what the Former Treasurer referred to as a "firestorm."
73 . The Former Treasurer detailed the exact events leading up to the accounting storm that actually did occur. On March 1, 2004, Red Hat's Accounting and Finance Departments began the annual process of closing the books and generating the required financial statements .
He explained that although Red Hat closed its books every month, the quarterly process was more involved. The witness said that throughout the first 10 to 14 days of March 2004, Red
Hat's accounting department was in the process of closing its books for the quarter and generating financial statements for that period . He said that at the end of the first 14 days of
March, the PWC audit team came out to audit Red Hat's financials associated with FQ1 . Once the numbers are approved by the Board, the audit partner can release the earnings results . He stated that by the time this process is completed, it is usually late March.
74. The Former Treasurer went on to explain that generally a Company has 90 days from its year end to file its 10K/Annual Report with the SEC (pursuant to General Instruction
A(2) to Form 10-K), which, in Red Hat's case, was May 31, so the Company has to have these reports finalized by approximately mid-May, allowing the audit team ample time to review them .
75. He said that during the months of March, April, and May 2004, Barber was still involved on the Red Hat engagement, as PWC's audit team conducted the process of completing the audit for the year ending February 29, 2004 . By May 31, 2004, the PWC auditors had completed their work, and Barber was rotated off of the Red Hat engagement . He said that on
25 May 31, 2004, Red Hat had come to the end of its first fiscal quarter for 2005, at which point the
Company again began the same process - i .e., for the next 10 - 14 days, the accounting department closed the books and generated and reviewed the requisite financial statements, after which time the PWC auditors began their audit .
H. PWC and the Defendants Know they Are in Imminent Dancer of Being Exposed
76. The Defendants had strong reasons to believe that the new auditor who woul d soon arrive at Red Hat would be a stranger to them, and would likely be unwilling to continue their fraud. The Former Treasurer explained that the offices of the four large accounting firms in
Raleigh are "relatively small ." He stated that when Barber had to be rotated off of the Red Hat engagement, there were only two other Audit Partners within the Raleigh PWC office from which to choose. He indicated that because the Raleigh office was so small, it was unlikely that the other two audit partners based there would have had the necessary technology expertise .
77. He pointed out that within North Carolina, there was a substantial amount o f manufacturing, banking and finance companies, and it is reasonable for one to deduce that the remaining audit partners in the Raleigh PWC office had expertise in these and/or related areas, as opposed to technology. He said that Barber was well known as a local technology partner, and
since Barber had to be rotated off of the Red Hat engagement, it was logical to conclude that the
new partner would be someone from outside the area.
I. The Individual Defendants Dump Their Stock
78. Faced with the impending prospect of having their fraud revealed to the market,
and knowing that the new auditor would be reviewing Red Hat's financial statements for fiscal
year 2005, which was to begin on March 1, 2004, the Individual Defendants began to illegally
sell millions of dollars worth of their personal stock, with a staggering amount of sales takin g
26 place in February 2004 and continuing through May 2004, all of which encompassed the quarter which the new auditor would be addressing .
79. The details of Defendants' insider trading are addressed in full in Section XII .B. of this Complaint, but it is worth noting here that CFO Thompson sold 135,000 shares for $2 .9 million between January and April 2004, while CEO Szulik dumped 1 .2 million shares for proceeds of approximately $22 million in February 2004 alone . For two men with salaries of
$350,000 and $250,000 per year in fiscal year 2004, this represented an enormous profit .
J. The PWC Replacement Auditor Arrives at Red Hat
80. The Former Treasurer recalled that when Barber "rolled off' the Red Ha t engagement in the fiscal year ending February 29, 2004, Victor Petri, who was based in PWC's
Boston office, replaced Barber as Red Hat's audit partner . He explained that Barber signed off on the opinions for the audit ending on February 29, 2004, and Petri was assigned as Red Hat's new audit partner for the Red Hat fiscal year beginning March 1, 2004 . The witness maintained that Petri did not really "get into" reviewing Red Hat's financials until June of 2004, when Petri
and his audit team were in the process of reviewing the Company's financial statements for the
quarter ending May 31, 2004.
81 . The witness stated that the first time Petri was asked to look at or review Red
Hat's financials in his role as Red Hat audit partner was when the Company completed its first
fiscal quarter ending May 31, 2004, so the beginning of June 2004 was the first time that Petri
went to Red Hat's Corporate Office to begin the auditing process for the first quarter of the new
fiscal year. So, on May 31, 2004, Red Hat's accounting department closed its books for the
quarter ending May 31, 2004, at which time the PWC engagement team "came out" to the Red
Hat premises to review the Company's books.
27 VI. THE TRUTH REGARDING RED HAT'S REVENUE RECOGNITION SCHEME IS PARTIALLY REVEALE D
A. Monday, June 14, 2004 -- The CFO Bails Ou t
82. Less than two weeks after Petri and his team began their initial review of Re d
Hat's books, on Monday, June 14, 2004, after the market closed at 4 :00 p.m. EST, Red Hat suddenly and unexpectedly announced in a prepared statement that CFO Thompson would be resigning "to pursue other interests." Red Hat added that Defendant Thompson was expected to continue as CFO until the search for his successor was completed .
83 . TheStreet.com, a highly respected investment advisor and leading provider of investment commentary, advice, research and news, reacted on June 14, 2004, stating that "[t]he abrupt resignation, coming just three days before the company is scheduled to report fiscal 2005 first-quarter earnings, puzzled Wall Street ." The article further quoted an analyst's comments, stating "[e]veryone hates uncertainty. Why wouldn't they wait until earnings? This puts even more of a spotlight on Thursday's report ."
84. Inside the company, the Former Inside Account Executive confirmed that th e
CFO's resignation was "highly unexpected," and that "nobody saw that coming ," while the
Former Regional Account Manager, who held a higher position at Red Hat, said that he and the other sales personnel at the corporate office believed that the timing of the two events and
Defendant Thompson's stated reason for his resignation were "tot al bullshit." He and his fellow
sales personnel believed that Defendant Thompson had resigned because he was aware of the
impending earnings restatement announcement and the negative impact this would invariably have on Red Hat 's stock price. The witness recalled that as soon as the earnings restatement was
announced, the internal sales staffcollectively exclaimed, "Oh, that's why he [Defendant
Thompson] left."
28 85. Adding further evidence that Defendant Thompson's departure was fallout from the revenue recognition scheme is Defendant Thompson's separate statement, reported by the
Associated Press Worldstream that same evening (June 14, 2004), that the reason he was leaving was to spend "some additional time with my family ." However, Defendant Thompson's famil y excuse has now been exposed as manufactured . The News & Observer followed up on
Defendant Thompson's excuse on December 26, 2004, making the following observation in its
Christmas "gifts" to the "naughty and nice" : "To Kevin Thompson, who left his position as chief financial officer at Red Hat, a Raleigh software company, to spend more time with his family and yet ended up becoming CFO at SAS, a Cary software company: a two-week vacation with the wife and kids."
86. As a consequence of the June 14, 2004 announcement of the CFO's unexpecte d resignation, which was directly related to the premature revenue recognition scheme employed by Defendants, Red Hat's stock, which was inflated throughout the Class Period due to
Defendants' fraudulent scheme, dropped 12 .55% in after hours trading on June 14, 2004 from a close of $24 .30 to an after-hours low of $21 .25, causing damages and economic loss to Lead
Plaintiffs and the other members of the Class .
B. Tuesday, June 15, 2004 - Defendants' Continue to Panic
87. Under enormous pressure, and with their scheme rapidly unraveling, Red Hat panicked the following day, releasing, just minutes prior to the market's opening on Tuesday,
June 15, 2004, an unexpected "preview" of earnings and subscriptions volumes for the first
quarter of fiscal 2005 ended May 31, 2004, announcing that the Company expected to report net
income of over $10.0 million, or $0.05 per share, for the first fiscal quarter 2005, and operating
income in the range of $4.7 million.
29 C. Wednesday, June 16, 2004 - The New Auditor " Drops the Bomb"
88 . Meanwhile, back at Red Hat's corporate headquarters, Defendants and Barber's worst fears about the new auditor were about to come to fruition . The Former Treasurer recalled that after Petri's arrival in early June 2004, Petri was not at the Red Hat premises every day, but was shuttling back and forth between Boston and Raleigh during the Quarterly Review audit .
But even with Petri not working on site at Red Hat's headquarters full time, it didn't take long for him to discover Defendants' scheme .
89. The Former Financial Analyst in the Accounting Department and the Forme r
Treasurer both explained that on the morning of June 16, 2004 Petri informed Red Hat management, including Defendant Thompson and Senior Finance Manager Bart Kalsu, that he wanted Red Hat to change the Company's revenue recognition practice from a monthly basis to a daily basis. The Treasurer, who referred to this as Petri "dropping the bomb," said Petri stated that he had to cover himself, and that Barber may have been comfortable signing off on the audit opinions, but that he (Petri) was not .
90. The Treasurer said that after the "bomb" was dropped, he (the Treasurer),
Defendant Thompson, and several other individuals worked overnight on June 16, 2004 manually running the financials on a daily revenue recognition method. According to this witness, just one business day later, on June 17, 2004, the final decision was made by Petri to change Red Hat's revenue recognition method . Once Petri determined that Red Hat was going to have to restate its financials, Petri said that "if the shit is going to hit the fan and the SEC is down
on us and there are law suits, they will come after me . . ..I am not comfortable with this ."
D. Thursday, June 17, 2004 - Defendants' Announce Earnings Shortfall
91 . On Thursday, June 17, 2004, just three days after announcing the CFO's
resignation, and two days after its "preview," Red Hat announced its first quarter results for th e
30 fiscal quarter ended May 31, 2004, revealing that its revenues of $41 .6 million fell short of the
Company's guidance of $42 .5-43.5 million and consensus expectations of $43 million .
92. As a consequence of this unanticipated revenue miss on June 17, 2004, which was directly related to the premature revenue recognition scheme employed by Defendants, Red
Hat's stock, which was inflated throughout the Class Period due to Defendants' fraudulent scheme, dropped 10 .23% from a close of $22 .39 on June 17, 2004 to close at $20.10 on June 18 ,
2004, causing damages and economic loss to Lead Plaintiffs and the other members of the Class .
93. Red Hat made the number 2 spot on TheStreet.com's June 18, 2004 "The Five
Dumbest Things on Wall Street This Week." In response to the strange actions of Red Hat in unexpectedly issuing a preview of earnings one day after announcing the CFO's resignation and two days before releasing actual earnings, TheStreet.com reported: "Some companies aren't distracted by the vicissitudes of the market . They key their eye on the operational big picture, not the tiny ups and downs of their stock price. They take the long view. Red Hat, we learned this week, is not one of those companies."
94. Also on June 17, 2004, an interview of Defendant Szulik by Bloomberg reporter
Dina Bass ("Bass") was broadcast on Bloomberg. During the interview, Bass asked Defendant
Szulik why the Company announced Defendant Thompson's resignation and pre-announced its financials results for the first quarter of fiscal year 2005 just days before the Company formally announced its first quarter financial results on June 17, 2004. Defendant Szulik responded to
Bass by first representing that Red Hat "prides itself on transparency not only in its software code, but as part of its overall corporate governance strategy." Defendant Szulik went on to state that many analysts believed that Defendant Thompson's resignation was a precursor to further
"negative news, i .e., a financial restatement or SEC investigation," and therefore, the Company
31 wanted to "reassure investors that that was not happening and more importantly that the health of the business was strong."
E. Barber's Tries to Cover His Tracks
95 . Again, back at Red Hat, Barber and the Defendants had now been caught red- handed, and Barber scrambled to protect himself. Of course, as the Former Treasurer explained,
Barber knew that revising the fraudulent revenue recognition policy during his tenure as the
Audit Engagement Partner would have "raised flags," and would have caused "a ruckus ." But now the "ruckus" was here, and the firestorm was in full play.
96. Increasingly desperate, and engaged in a futile effort to cover his tracks, Barbe r
was determined to try and fix the problem if he could. As the Former Treasurer explained, there
was approximately a 21-day period during the last half of June 2004 and the first part of July
2004, during which Petri and his staff were in the process of analyzing the previous quarters
(which were subsequently restated). Amazingly, as the Former Treasurer revealed, even though
Petri had taken over as Red Hat's engagement partner and Barber was no longer assigned to
work on the Red Hat account, Barber continued to travel "back and forth" to the Red Hat
premises during this 21-day time frame.
97. The witness said that Barber's interest in returning to the Red Hat premises durin g
this 21-day time frame was that he did not want Petri to make him "look bad," and, more
importantly, Barber did not want to be susceptible to litigation and liability . The Former
Treasurer distinctly remembered being informed by the PWC audit staff members that
throughout this 21-day timeframe, upon each return visit to the Red Hat premises, it was clear to
them that Barber was losing approximately 10 pounds a week and reportedly was not sleeping
much, if at all . Barber had reportedly informed the audit team members that he was "nauseous"
and unable to sleep .
32 98 . The witness understood that PWC was "also looking out for itself' and its own possible exposure to liability and litigation, and that at some point during this time, PWC recognized that Barber's continued presence during the 21-day analysis of the previous quarters represented a possible conflict of interest, in that Barber may have been pressuring the audit team, several of whom used to report to Barber during his tenure as Red Hat's engagement partner. Finally, at one point during this 21-day time frame, senior PWC personnel admonished
Barber for continually returning to the Red Hat premises even though he was no longer on the engagement, telling Barber in no uncertain terms "don't go back [to the Red Hat premises] ."
VII. THE TRUTH REGARDING RED HAT'S REVENUE RECOGNITION SCHEME IS FINALLY FULLY REVEALED
A. End Of Class Period: Defendants Announce Restatement And SEC Inquiry
99. One month later, on July 13, 2004, before the opening bell, the Company stunned the market again . This time, and in a complete 180° turn from Red Hat's June 17, 2004 reassurance that a restatement "was not happening," Red Hat revealed to the public that it planned to restate its audited financial statements for the fiscal years ended February 28, 2002 ,
February 28, 2003, and February 29, 2004, and its unaudited financial statements for the fiscal quarter ended May 31, 2004 . The company said that the restatement was due to the correction in the manner in which the Company recognizes revenue for certain subscription agreements. The press release stated:
Red Hat today announced that it had corrected the manner in which it recognizes revenues for certain of its subscription agreements and, as a result, will restate its audited financial statements for the fiscal years ended February 29, 2004, February 28, 2003, and February 28, 2002, and its unaudited financial statements for the fiscal quarter ended May 31, 2004.
The decision results from recent discussions between the Company and the Company's independent auditors PricewaterhouseCoopers, following the normal rotation of audit partners required by the accounting profession's rotation rules . As a result of these discussions, the Company determined it would be appropriate
33 to stop recognizing revenue for subscription agreements on a monthly basis - a method it has consistently applied for the last five years - and start recognizing revenue on a daily basis over the particular contract term .
The restatement is due entirely to the correction in the Company's method of recognizing revenue for subscription agreements. The effect of using the new method is to defer a portion of the revenue that had been previously recognized in the month of commencement of a subscription to the month in which the subscription ends.
100. In the same July 13, 2004 press release, Red Hat also disclosed that the restatement "is expected to result in significant percentage differences in certain items such as quarterly operating profit and net income."
101 . The Company also said in the press release that PWC had informed them ofthe change in revenue recognition a month earlier on June 16, 2004 :
On June 16, 2004, the Company's independent auditors informed the Company that it should consider recognizing revenue from a subscription over the term of the subscription (for example, the number of days in the subscription period), which ultimately resulted in the Company deciding to change to this method . The resulting change will now mean that the Company will begin to recognize revenue on the date of commencement of a subscription and ratably over the remaining term of the subscription. The effect of the Company's decision is to defer a portion of the subscription revenues that would have been recognized in the month of the commencement of the subscription to the last month of the subscription term.
102. Trying desperately to spin the restatement as a non-event, Defendant Szulik state d
"[t]he restatement is not expected to reflect any material difference in the meaningful historical trends of our business, nor will it adversely affect our business outlook, which remains strong ."
The Company also revealed in its July 13, 2004 press release that it would not file its Form 10-Q for the first fiscal quarter 2004 on time. Rather, the Company anticipated filing its Form 10-Q on or before July 19, 2004 .
103. However, analysts knew how serious a situation this really was, and they peppered Defendant Szulik with questions during an analyst conference call that same day (July
34 13, 2004). For example, a Prudential analyst asked Defendant Szulik, "why did it take the auditor 5 years to raise this issue, I guess, why wasn't this raised earlier and what triggered them to raise this now versus few years ago . . ., - which seemed like the way that it should be done?"
Defendant Szulik replied "as we have discussed in the call that the discussion that resulted in our decision to make the restatement began on June 16, 2004 . And while prior discussions about the method had occurred early on, it has only been since the discussions that commenced from the 16th that we understood the need to make this correction."
104. But the bad news was not over yet. Defendants also revealed to the market in the
July 13, 2004, press release that Red Hat was "in the process of responding to prior comments and questions from the SEC regarding its Annual Report on Form 10-K ." Because of Red Hat's earlier reassurances on June 17, 2004 that an SEC investigation "vas not happening," it was again revealed that Defendants omitted to tell the public the full truth regarding the SEC inquiry .
105. Indeed, according to the Former Treasurer, the SEC inquiry began in April o f
2004, months before the release, when the SEC informed Red Hat that it had reviewed one of the
Company's filings and had questions. Red Hat was asked to provide certain information to the
SEC in order to address those questions, and the Company was forced to file a response with the
SEC. However, when Red Hat provided this additional information, it reportedly gave rise to
more questions. According to the Former Treasurer, when Defendant Thompson initially
received the SEC inquiry letter, he shared the correspondence with a PWC auditor, who shared
the letter with the then-audit partner, Jeff Barber . However, Defendant Thompson waited to
focus on the SEC inquiry until after Red Hat announced results for the first fiscal quarter ended
May 31, 2004 .
35 106. As a consequence of the news of the morning of July 13, 2004, which was directly related to the premature revenue recognition scheme employed by Defendants, Red Hat stock, which was inflated throughout the Class Period due to Defendants' fraudulent scheme, plunged 22.7% from $20.35 per share to $15 .73 per share on July 13, 2004, on unusually high volume of 55,783,888 shares, far greater than the Company's average daily trading volume during the Class Period of 3,518,357 shares, causing damages and economic loss to Lead
Plaintiffs and the other members of the Class . In fact, it was the largest one day drop Red Hat's stock had ever suffered .
107 . News of Red Hat's restatement was met with much dismay in the financia l markets. The timing of the announcement, coupled with other bad news, called Red Hat's credibility into question. As eWeek.com stated in a July 13, 2004, article, "[t]he market [] doesn't like this change one bit . . . The shorts and longs battled it out on the frantic Red Hat financial message boards at Yahoo . Some shorts asked, `why didn't management say anything during the June conference call?' Others suggested that Red Hat's previous chief financial officer resigned two weeks before the last earnings call because he knew `the books were cooked."'
108. In fact, on July 16, 2004, TheStreet.com ranked the Red Hat restatement announcement as one of "The Five Dumbest Things on Wall Street This Week ." As the article reported, "[a]t Red Hat, the hits just keep on coming. Or more accurately, the body blows . []
More alarming than the revelation of the now-discredited policy - after all, who among us hasn't slid revenue forward 20 days every now and then? - are some other disclosures the company made in the course of explaining the revenue problem to analysts . First, though the Company
36 started out saying that PWC brought the revenue problem to its attention on June 16, Red Hat said on the call that in fact, the problem had previously surfaced at some time in the distant past ."
109. Client Server News, in a July 19, 2004 article, also considered the restatement to be a credibility issue. In addition, as reported in the same article, Prudential stated that the June and July 2004 events and assertions from Red Hat "call into question the timing and judgment of
Red Hat management," leading investors to question whether Red Hat was completely up front on these issues. The article also said that "stockholders are wondering why, i f
PricewaterhouseCoopers raised the recognition issue on June 16, like Red Hat CEO Matthew
Szulik said, and if Red Hat had its Q1 recalculations in hand by June 17 when it reported its QI results, again like Defendant Szulik said, why the heck it didn't say it was using a different revenue recognition policy then since the switch lowered revenues to $41 .6 million, below the
$42 .5 million to $43 million it guide[d] towards ."
110. Analysts now began to raise numerous serious questions about Red Hat' s credibility . For example, Red Hat analyst FTN Midwest Research commented on July 15, 2004,
"when you look at the timeline, the timing is so bizarre, there are some concerns about management credibility." In fact, during a July 13, 2004 conference call, FTN Midwest
Research told Defendant Szulik and Defendant Thompson that it was "quite disconcerting" and that "all the timing [ ] doesn't seem to be quite in sync ." During this conference call, FTN
Midwest also stated that it was "quite amazed," questioning whether this was "the start of more accounting issues, or is it the end?" Another Red Hat analyst, the John Hancock Technology
Fund, was reported by TheStreet.com on July 13, 2004, as saying "[y]ou have some credibility issues there." John Hancock also suggested that Red Hat management's credibility has been
37 called into question because the Company didn't disclose the change when it announced it s quarterly results on June 17, 2004.
111 . In fact, as the Defendants knew, the timing of the restatement was not bizarre a t all, but rather a calculated effort to withhold information from investors for as long as they could, in order to maximize their own personal profits through insider sales, as detailed in I¶ 272-28 3 of this Complaint .
112. Several analysts also lowered their valuation ranges for Red Hat. For instance,
Wachovia Securities lowered their valuation range for Red Hat from $21-$25 to $15-$17 .25, due to heightened business uncertainty and risk relating to Defendant Thompson's resignation an d the accounting-related disclosures.
113. These questions and concerns lingered with analysts long after the dust had settled. For example, in an August 27, 2004, article by The News & Observer, Red Hat analyst
Canis & Company was quoted as saying "[w]e lost a whole lot of belief that everything was under control as they shot themselves in various feet and other appendages . The market is really waiting for management changes or other events that would boost people's confidence."
VIII. DEFENDANTS' FALSE AND MISLEADING STATEMENT S
A. The Class Period Begins: Defendants Issue False Financial Results For 3003 (ended November 30, 2002)
114. On December 17, 2002, the Company released its results for the third fiscal quarter ended November 30, 2002, in a press release entitled, "Double-Digit Sequential
Revenue Growth, Positive Cash Flows from Operations Highlight Red Hat's Third Quarter
Results: Enterprise subscription revenues grow 29% sequentially, operating cash flows reach
$1 million." Specifically, the Company reported in part :
38 Red Hat achieved revenue of $24.3 million, a sequential increase of 14% compared to $21 .2 million in the second quarter of fiscal 2003 , and a year-over-year increase of 21%.
For the third quarter of fiscal 2003 the company reported a net income of $305,000,3 or break-even per share. This compares to a net loss of $2.0 million, or $0.01 per share, in the prior quarter, and a net loss of $15 .1 million, or $0.09 per share in the same quarter a year ago.
115. The Company summarized third quarter fiscal highlights as follows :
• Enterprise revenues, which account for 93% of Red Hat's total revenues, grew 15% to $22 .5 million. • Enterprise subscription revenues jumped 29% and generated gross margins of 82% .
• Sales of Advanced Server increased to 12,000 subscriptions, a 50% increase compared to the prior quarter .
116. Defendant Thompson commented : "Accelerating growth of our enterpris e subscription revenues and positive operating cash flows are evidence of Red Hat's scalabl e business model."
117. Defendants hosted a conference call with analysts on December 17, 2002, after the earnings release, in which Defendants Szulik, Thompson and Buckley participated . During the call, Defendants repeated the results for the third fiscal quarter 2003 announced the same day.
118. The financial results announced on December 17, 2002 were repeated and incorporated into the Form 10-Q filed with the SEC on January 10, 2003, for the third quarter of fiscal year 2003 . The Form 10-Q was signed by Defendants Szulik and Thompson .
119. The Form 10-Q included certifications from Defendants Szulik and Thompson, a s required by Section 9 .06 of the Sarbanes-Oxley Act of 2002, that to their best knowledge, the quarterly report "fully complies with the requirements of Section 13(a) or 15(d) of the Exchang e
3 The 3Q03 Form 10-Q shows net income of $214,000. See 1121 below.)
39 Act of 1934" and "the information contained in the Quarterly Report [] fairly presents, in al l material respects, the financial condition and results of operations of Red Hat, Inc ."
120. Defendants Szulik and Thompson also certified the internal controls of the
Company, stating:
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have :
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared ;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the `Evaluation Date") ; and
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date.
121 . The 3Q03 Form 10-Q reported results as follows:
3 04 Reported Total Revenue $24,278,000 Gross Profit $16,090,000 Income (loss) from ($2,894,000) operations Net Income (loss) $214,000
122. The Form 10-Q explained the Company' s revenue recognition policy as follows:
We recognize revenue in accordance with Statement of Position No . 97-2, "Software Revenue Recognition" ("SOP 97-2"), as amended by SOP 98-4 and SOP 98-9, and SEC Staff Accounting Bulleting No . 101 ("SAB 101"). Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of our sales transactions 4
4 This policy is repeated in Form 10-K for FY2003 and the Forms 10-Q for 1Q04, 2Q04 and 3Q04 filed by the Company during the Class Period . The language of the policy changes slightly thereafter. See ¶175.
40 123. The Form 1O-Q explained that enterprise subscription revenue is recognized as follows:
In accordance with the provisions of SOP 97-2, we recognize all of the revenue from the sale of our subscription based products ratably over the period that the subscription services are provided. Revenues from sales of Advanced Server is recognized over the twelve month period that subscription services are provided .
Direct software sales are recognized over the period that subscription services are provided beginning when shipped, as these customers purchase on the Company's on-line web store . Revenue from our OEM arrangements are recognized over the subscription period beginning on the date we are notified that sales have been made.
Subscription relationships with large enterprise customers typically involve contracts with multiple elements (i.e., delivered and undelivered products, maintenance and other services) . The Company allocates revenue to each component of the contract based on objective evidence of its fair value, which is specific to the Company . The fair value of each element is based on the price if sold separately. The Company recognizes revenue allocated to undelivered products when the criteria for product revenue set forth above have been met. Subscription revenue also includes revenue from large Unix to Linux migration arrangements . Revenue from these arrangements has historically been recognized ratably over the term of the arrangement as no other pattern of performance is discernible, none of the elements are essential to the functionality of the software and specific evidence of the fair value of the elements has not been established .
Revenue from technical support and maintenance services is recognized ratably over the term of the related technical support and maintenance agreement . ** *
RHN is sold in the form of a monthly subscription and revenue is recognized ratably over the subscription period .
124. The Form 1O-Q explained that embedded subscriptions revenue is recognized as follows:
Revenue is deferred and recognized ratably over the term of the agreement, which is typically twelve months.
41 B. Reasons for Falsity: 3003
125 . The statements contained in 11114-124 above were materially false an d misleading because, as revealed in Red Hat's Form 10-K/A filed with the SEC on August 4,
2004:
a) total revenues for the third fiscal quarter 2003 were actually $23,655,000, not the
$24,278,000 reported;
b) gross profit for the third fiscal quarter 2003 was actually $15,018,000, not the
$16,090,000 reported, a decrease of 6 .66%;
c) loss from operations for the third fiscal quarter 2003 was actually $3,897,000, not the loss of $2,894,000 reported, a decrease of 34.66%; and
d) net loss for the third fiscal quarter 2003 was actually $789,000, not the income of
$214,000 reported, a decrease of 468.69%.
126. The statements described above in IN 114-124 were also materially false and misleading for the reasons stated in this Complaint, including because :
a) Defendants materially inflated and falsified Red Hat's reported revenues, ne t income, operating profit, forecasts, general financial condition, and other financial informatio n by prematurely recognizing revenue from subscription contracts that had not yet been earned.
b) Defendants misled investors by repeatedly informing them Red Hat was deferrin g revenue ratably over the period of the subscription (or term of the agreement), when in fact Red
Hat was secretly recognizing revenue before the subscription had begun.
c) Defendants failed to disclose that Red Hat's definition of recognizing revenu e ratably over the period of the subscription (or term of the agreement) meant that it was back- dating revenue to the beginning of each monthly period, and thereby materially inflating an d
42 falsifying its quarterly, yearly, and other financial reports and information it provided to investors.
d) Defendants failed to disclose to investors that Red Hat's financial statements failed to comply with GAAP and GAAS, including Defendants' false assurance that its financial statements were in compli ance with SAB 101 and SOP 97 -2 as described in this Complaint.
C. Defendants Release False Fiscal Year 2003 Year End Financial Result s
127. On March 25, 2003, the Company announced results for fourth quarter and fisca l year ended February 28, 2003 . Regarding the Company's fiscal year 2003 ended February 28,
2003, the March 25 press release stated in relevant part :
The company reported revenues of $90 .9 million, an increase of 15% as compared to fiscal 2002 revenues of $78.9 million. The company reported a net loss of $6 .4 million for fiscal 2003, or $0.04 per share, compared to a net loss of $140 .2 million, or $0 .83 per share, for fiscal 2002.
128. Defendant Thompson stated in the press release that "[t]hrough stron g performance of all our enterprise technologies, Red Hat was able to achieve steady, consisten t growth in fiscal 2003."
129. Defendants also hosted a conference call on March 25, 2003, after the earning s release, in which Defendants Szulik, Thompson and Buckley participated . Defendant Szulik opened the conference call repeating the results for fiscal year 2003 .
130. Defendant Thompson also summarized the results for fiscal year 2003 and further stated:
For the current fiscal year, we had a GAAP net loss of $6 .4 million or a net loss of 4 cents per share as compared to a GAAP net loss of $140 .2 million, or a loss of 83 cents per share for the prior fiscal year .
131 . Defendant Thompson explained the importance of subscriptions on revenu e growth:
43 There are several factors that are important to understand to properly project the impact of these subscriptions on our future Enterprise subscription revenue growth . First, approximately 30% of our sales of Red Hat Enterprise Linux to date represent migration of existing customers off of a prior Red Hat operating system to the Red Hat Enterprise Linux platform . These migration subscriptions initially create a relatively small amount of incremental revenues or on a quarterly basis . However, are strategically important as we continue to successfully convert our customers to a recurring per-service subscription model based on Enterprise Linux from the Enterprise relationship model that they were on previously . Second, approximately 4,000 subscriptions of the Advanced Server subscriptions sold in Q4 will be deployed late in calendar 2003, and, therefore, we will not begin to recognize revenue on these subscriptions until such time as the technology is deployed.
132 . Defendant Thompson forecasted for 1Q04 that another quarter of strong sequential revenue growth in 1 Q04 "will be led by sales of subscriptions to Red Hat Enterprise
Linux AS, ES and WS ." Defendant Thompson predicted for 1Q04 that "[t]otal revenues will b e in the range of [$]27 million to $27.5 million, which represents a growth rate of 4 to 6% over
Q4."
133. In discussing the Company' s revenue recognition policy with an analyst,
Defendant Thompson stated:
as you look at our balance sheet and our deferred revenue balance, our revenues are recognized monthly, and our deferred revenues are driven by the payment terms and billing terms we have with our customers, so the growth in deferred revenue relates to both the timing of the bookings of subscriptions during the quarter and how much the customers agree to pay up front versus what they decide to pay quarterly .
134. On May 29, 2003, the Company filed its Form 10-K Annual Report . The Form
10-K repeated in substantial part the results for fiscal year 2003 provided in the Company's
March 25 press release, as well as the results for third quarter 2003 announced December 17,
2002. The Form 10-K is signed by, among others, Defendants Szulik and Thompson and contains the same certifications of Defendants Szulik and Thompson as in the 3Q03 Form 10-Q .
(See In119-120 above).
44 135. The Form 10-K repeated the general revenue recognition policy quoted above i n
¶122. The Form 10-K further explains recognition of enterprise subscription revenue as follows:
We recognize revenue from the sale of our enterprise offerings ratably over the period of the subscription. Our subscription relationships with our large enterprise customers typically have contracts with multiple elements (i .e., delivered and undelivered products, maintenance and other services) . We allocate revenue to each component of the contract based on objective evidence of its fair value, which is specific to us. The fair value of each element is based on the price if sold separately. Enterprise subscription revenue also includes revenue from several large Unix to Linux migration arrangements which were sold prior to the release of Red Hat Enterprise Linux in May 2002 . Revenue from these arrangements has been recognized ratably over the term of the arrangement, as no other pattern of performance has been discernible nor has there been specific evidence of the fair value of the elements of these arrangements .
*~ s
We sell Red Hat Linux subscription solutions through four channels: direct sales, original equipment manufacturers ("OEMs"), value-added resellers and the Internet . Revenue recognition periods for each channel are based on the subscription period with Red Hat that the end purchasers of the subscriptions from these channels receive, which is generally one year .
Red Hat Enterprise Network is sold in the form of a monthly or annual subscription. Revenue is recognized ratably over the subscription period .
136. The Form 10-K explains recognition of retail revenue as follows :
Through our retail distributors, we sell Red Hat Linux Consumer products . . . . We recognize all of the revenue from the sale of Red Hat Linux ratably over the period that the subscription services are provided .
137. The Form 10-K explains recognition of embedded subscription revenue as follows:
Embedded subscription revenue consists of revenue for technical support and maintenance services provided pursuant to software compiling, debugging, and
45 optimization agreements . Revenue is recognized ratably over the term of the agreement, which is typically 12 months . 5
138 . In addition, contained in the Company's Fonn 10-K was a Report of Independen t
Accountants by PWC, dated March 25, 2003 . In this Report, PWC assured investors that the
Company conformed with GAAP and stated the following:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders' equity, and of cash flows present fairly, in all material respects, the financial position of Red Hat, Inc . and its subsidiaries at February 28, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended February 28, 2003 in conformity with accounting principles generally accepted in the United States of America . These financial statements are the responsibility of the Company's management ; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation . We believe that our audits provide a reasonable basis for our opinion.
D. Reasons for Falsity: Fiscal Year 2003 (Ended February 28, 2003 )
139. Defendants' statements detailed above in ¶1127-131 and 133-138 were materially false and misleading , because, as revealed in Red Hat's Form 10-K/A filed with the SEC on
August 4, 2004:
a) Total revenues for fiscal year 2003 were actually $90,275,000, not the
$90,926,000 reported ;
b) Gross profit was actually $59,256,000, not the $59,464,000 reported ; and
c) Third fiscal quarter 2003 results were actually as detailed in ¶125 above ;
5 The Company's revenue recognition policies appear twice in the Form 10-K : First, in Management's Discussion and Analysis, and also in the Notes to the Consolidated Financial Statements .
46 140. The statements described in ¶1127-138 above, including PWC's Report o f
Independent Accountants, are also materially false and misleading for the reasons stated in ¶12 6 above.
141 . Defendant Thompson's forecasts for 1Q04 detailed in 1132 above were materiall y false and misleading, because, as revealed in Red Hat's Form 10-K/A filed with the SEC on
August 4, 2004, the total revenues for first fiscal quarter 2004 were actually $26,124,000 .
E. The Fraud Continues: First Ouarter Fiscal Year 2004 (Ended May 31, 2003 )
142. On June 17, 2003, the Company announced its first quarter results for fiscal yea r
2004, which ended on May 31, 2003. The Company's press release reported in part:
Red Hat achieved revenue of $27 .2 million, a sequential increase of 5% compared to $25 .9 million in the fourth quarter of fiscal 2003, and a year-over-year increase of 39%.
143 . The Company summarized highlights for the first quarter as follows :
• First quarter sales of annual subscriptions for the Red Hat Enterprise Linux family of technologies increased sequentially by 2,000, or 10%, to 23,500 subscriptions. • Subscription revenues from Enterprise Technologies grew 14% sequentially and 104% year-over-year . • Blended gross margins remained strong at 68%, while gross margins of Enterprise subscription technologies, including retail revenues, also remained strong at 82% . • Continued scaling of the business model, as the sequential reduction in the company's operating loss of $1 .3 million equated to the sequential increase in revenues .
144. Defendant Thompson commented on the results : "Red Hat continues to sho w strong operating performance, including sold growth in cash flows, deferred revenues, and net income, which translates into continued leverage of our business model ."
145 . In a conference call with analysts after the earnings release on June 17, 2003, in which Defendants Szulik, Thompson, Buckley, and Webbink participated, Defendant Szuli k
47 reiterated the strong financial performance results . Defendant Thompson then continued with an assessment of subscription revenues:
we experienced our third sequential quarter of increases in option and sales of our Red Hat Enterprise Linux technologies with sales of subscriptions to Red Hat Enterprise Linux reaching 23,700 units in the first quarter, a sequential increase of 10% as compared to sales of 21,500 subscriptions in the fourth quarter of fiscal 2003 .
Third, in Q1, enterprise technology subscription revenues increased by $1 .5 million or 14% to $12.3 million as compared to the fourth quarter of fiscal 2003, and increased by $6.3 million or 104% as compared to the same p rior year quarter.
Q1 continued to show significant growth in our enterprise technology subscription revenues, which increased by $1 .5 million or 14% as compared to the fourth quarter of fiscal 2003 and $6 .2 million or 104% as compared to the same prior year quarter. The significant increase in enterprise technology subscription revenues are being driven by the recognition of revenues from the sales of subscriptions to Red Hat enterprise Linux, which increased to 23,700 subscriptions in the first quarter from 21,500 subscriptions in the preceding quarter.
146. Defendant Thompson reiterated that the Company's "revenue recognition practic e is that we recognize revenues from the sales of subscriptions to Red Hat Enterprise Linux ratably over the period of the subscription, which is generally one year."
147. The first quarter fiscal year 2004 financial results announced on June 17, 2003 were repeated and incorporated into the Form 10-Q filed with the SEC on June 27, 2003 . The
Form 10-Q was signed by Defendants Szulik and Thompson and contained the sam e
certifications of Defendants Szulik and Thompson as in the 3Q03 Form 10-Q . See ¶¶119-120
above).
148. The Form 10-Q reported total revenues for 1 Q04 of $27,182,000 ; gross profit o f
$18,430,000; and net income of $1,506,000. The Company said that in 1Q04, the Company sol d
48 approximately 36,500 subscriptions to its Red Hat Enterprise Linux platform, stating : "This significantly exceeded management's expectations of the number of subscriptions to be sold in the initial year of the release of the Red Hat Enterprise Linux technologies. . . . Our ability to continue to increase market penetration and maintain competitive pricing for our enterpris e technology subscriptions are critical to our success ."
149. The 10-Q also states:
Enterprise technologies revenue increased 103 .8% to $12 .3 million for the three months ended May 31, 2003 from $6 .0 million for the three months ended May 31, 2002. The increase is directly related to the units of Red Hat Enterprise Linux sold in previous quarters. These Enterprise offerings are important as they are sold with renewable subscriptions and all have twelve month revenue recognition periods to match the related support obligation . As a result of our twelve month revenue recognition policy, for each unit sold in a given quarter, we recognize a portion of the revenue related to that unit in the current quarter, based on the period of time between the date of the sale and the end of the quarter, and the remainder in subsequent quarters. For the three month period ended May 31, 2003, we sold approximately 23,700 subscriptions to our Red Hat Linux AS, ES and WS platforms .
150. Defendants repeated that the Company recognizes revenue ratably over the period ofthe subscription, repeating the revenue recognition policy summarized in the 3Q03 Form 10-Q
see ¶122 above) and revenue recognition policies for enterprise, retail and embedded revenues outlined in the FY03 Form 10-K see ¶¶135-137 above) .
F. Reasons for Falsity: 1004
151 . Defendants' statements detailed above in ¶1142-150 were materially false and misleading, because, as revealed in Red Hat's Form 10-K/A filed with the SEC on August 4 ,
2004:
a) Total revenues for first fiscal quarter 2004 were actually $26,124,000, not the
$27,182,000 reported;
49 b) Enterprise technologies subscription revenues were actually $11,872,000, not the
$12,289,000 reported;
c) Gross profits for the first fiscal quarter 2004 were actually $17,742,000, not the
$18,430,000 reported; and
d) Net income for the first fiscal quarter 2004 was actually $1,047,000, 30.48% lower than the $1,506,000 reported .
152 . The statements described above in ¶¶142-150 are also materially false an d misleading, for the reasons stated in ¶126 .
G. The Fraud Continues : Defendants Issue False 3004 Results
153. On December 18, 2003, the Company issued its earnings release for the third quarter of fiscal year 2004 (ended November 30, 2003) after the close of trading . In a press release title, "Red Hat Delivers Record Revenue, Cash Flows From Operations, and Operatin g
Income in Third Quarter" the Company announced:
Red Hat reported revenue of $33.1 million, a sequential increase of 15% compared to $28 .8 million in the second quarter of fiscal 2004, and a year- over-year increase of 36% .
154. The release highlighted the following achievements for the quarter:
Third quarter sales of annual subscriptions for the Red Hat Enterprise Linux family of technologies increased sequentially by 7,000 subscriptions, or 27%, to approximately 33,000 subscriptions. Renewal rates for Red Hat Enterprise Linux approximated 90% for the second consecutive quarter . Deferred revenue increased 40% sequentially, to $42.3 million. Gross margins remained strong, with blended gross margins at 72%, and gross margins of Enterprise subscriptions remaining constant at 88%.
155 . Defendant Thompson, commenting on the results, stated, "Our revenue growt h accelerated in the third quarter, which translated to increased operating income and cash flows
50 from operations. The subscription revenue model has developed sufficient maturity to enable u s to drive consistent sequential increases in quarterly revenue . "
156. Defendants also hosted a conference call with analysts on December 18, 2003, i n which Defendants Szulik and Thompson participated . Gabriel Szulik, Red Hat's Director o f
Investor Relations and Defendant Szulik's brother, and Defendant Thompson summarized th e quarterly results.
157. Defendant Thompson reiterated the Company's revenue recognition policy:
As a reminder to all those on the call, our revenue recognition practice is that we recognize revenues from the sales of subscription to Red Hat Enterprise Linux, Red Hat Enterprise Network, and Red Hat Enterprise Application ratably over the period of subscriptions which is generally one year.
158. Defendant Thompson again touted the Company's subscription model for revenue growth:
Our confidence continues to grow in our ability to drive strong sequential quarterly growth in our Enterprise system. Sequential revenue growth will be led by recognition of revenues from sales of cumulative subscriptions to Red Hat Enterprise Linux, which total approximately 141,000 subscriptions at November 30, 2003 . And continued growth in our Enterprise Services revenue. Our subscription business model already provides significant visibility into the source of our revenue growth. As our model continues to mature, this visibility will continue to improve.
159. Defendant Thompson stated that he anticipated the Company's future financial performance would be as follows :
Full GAAP net income will be in the range of $5 .5 million to $5 .8 million or 3 cents per share. For purposes of earnings per share we have assumed that our fully diluted shares outstanding are 186 million shares . Subscription volume from the Red Hat Enterprise Linux subscription in 2004 will be at least 40,000 new subsc riptions.
160. The market reacted favorably to this announcement. Red Hat shares ro se $3 .2 1 per share, or 22 .48%, from its previous close of $14 .28, to close at $17.49 per share on
December 19, 2003 . Trading volume was unusually heavy at 32 .34 million shares.
51 161 . The financial results announced on December 18, 2003 were repeated and incorporated into the Form 10-Q filed with the SEC on January 6, 2004 for the third quarter o f fiscal year 2004. The Form 10-Q was signed by Defendants Szulik and Thompson and containe d the same certifications of Defendants Szulik and Thompson as in the 3Q03 Form 10-Q . (See
¶¶119-120 above).
162. Defendants repeated that the Company recognizes revenue ratably over the perio d of the subscription, repeating the revenue recognition policy summarized in the 3Q03 Form 10-Q
see ¶122 above) and revenue recognition policies for enterprise, retail and embedded revenue s outlined in the FY03 Form 10-K see ¶¶135- 137 above) .
163. Defendants indicated in the Form 10-Q that subscription revenue increased to
$22.0 million from $13 .2 million for prior-year same quarter and that enterprise technologies revenue increased 158 .0% to $17.8 million from $6.9 million for prior-year same quarter.
Defendants explained:
The increase is directly related to the subscriptions of Red Hat Enterprise Linux sold in previous quarters . These Enterprise offerings are important as they are sold with renewable subscriptions and generally have twelve month revenue recognition periods to match the related support obligation . As a result of our twelve month revenue recognition policy, for each unit sold in a given quarter, we recognize a portion of the revenue related to that unit in the current quarter, based on the period of time between the date of the sale and the end of the quarter, and the remainder in subsequent quarters . For the three month period ended November 30, 2003, we sold approximately 33,000 new subscriptions to our Red Hat Linux AS, ES and WS platforms compared to 12,000 subscriptions to Red Hat Enterprise Linux 2.1 in the same period in fiscal 2003 .
164. With respect to renewals of subscriptions, Defendants stated :
Unlike most proprietary software companies, we sell our enterprise software to our customers in the form of a renewable annual subscription . Our customers pay us an annual subscription fee for as long as they need to maintain a certified version of our software. Under our standard subscription agreements, prices to customers for the first annual renewal term are generally at the same price per installed system as during the initial one-year term, and for any subsequent renewal terms are based on current list prices. For our large enterprise customers, renewal rates often also reflect discounts fo r
52 increased subscription volume. Our subscription business model provides increased visibility into the sources of our enterprise subscription revenues as we generally recognize revenues from the sale of subscriptions ratably over the period of the subscription.
H. Reasons for Falsity: 3004
165 . Defendants' statements detailed above in ¶1153-158 and 160-164 were materially false and misleading, because, as revealed in Red Hat 's Form 10-K/A filed with the SEC o n
August 4, 2004:
a) Total revenues for third fiscal quarter 2004 were actually $32,883,000,not the
$33,088,000 reported;
b) Enterprise technologies subscription revenues were actu ally $17,210,000, not the
$17,779,000 reported;
166. The statements described above in ¶¶153-164 are also materially false an d misleading for the reasons stated in ¶126.
167. Defendant Thompson's forecasts for 4Q04 detailed in ¶159 above were materially false and misleading, because, as revealed in Red Hat's Form 10-K/A filed with the SEC o n
August 4, 2004, the net income for fourth fiscal quarter 2004 was actually $4,786,000.
I. Defendants Issue False 4004 and Fiscal Year 2004 Results
168. On March 23, 2004, the Company reported financial results for the fourth quarter and fiscal year ended February 29, 2004, stating:
Revenue for the fourth quarter of fiscal 2004 was $37.0 million, a sequential increase of 11 % compared to $33. 1 million in the third quarter of fiscal 2004, and a year-over-year increase of 43%.
For the fourth quarter of fiscal 2004, the company reported net income of $5 .0 million, or $0.03 per share. This compares to a net income of $4.1 million, or $0.02 per share, in the prior quarter, and break-even results in the same quarter a year ago .
The company generated $32.2 million, or $0.17 per share, in positive cash flow from operations during the fourth quarter , and a total of $61 million, or $0.33 per share, i n
53 positive cash flow from operations for the fiscal year ended February 29, 2004 . The company ended the year with a cash balance of $941 million, an increase of $649 million as compared to the balance at the end of the prior fiscal year .
In the fourth quarter of fiscal 2004, the company increased its deferred revenue balance to $70.8 million, a sequential increase of $28.6 million, or 68%, as compared to the third quarter of fiscal 2004.
169. Highlights for the fourth quarter and year end were summarized as :
• Fourth quarter sales of subscriptions for Red Hat Enterprise Linux technologies increased by 87,000 new subscriptions, comprised of 61,000 subscriptions sold into the enterprise IT market and 26,000 subscriptions sold into the HPC and hosting markets.
• Renewal rates for sales of Red Hat Enterprise Linux remained strong at approximately 90% .
• Gross margins increased to record levels, with blended gross margins at 76% and gross margins of Enterprise subscription technologies at 91%.
• Operating profit, before stock-based compensation, increased to $4 .6 million, or 12% of total revenue.
170. Again commenting on the Company' s results, Defendant Thompson stated, "For
Red Hat, fiscal 2004 was a year marked by great execution, as we delivered strong growth in revenues, cash flows, and profitability. The growth rates in the adoption of Red Hat Enterpris e
Linux has exceeded our expectations to date and we are positive on the outlook for fiscal 2005 ."
171 . A conference call with analysts also was held on March 23, 2004, in which
Defendants Szulik and Thompson participated and during which both Defendants Szulik an d
Thompson repeated the FY04 and 4Q04 results . Defendant Thompson added:
Third, growth rate in enterprise technology subscription revenues increased significantly into Q4. This growth is being driven by the leverage created from cumulative to (INAUDIBLE) subscriptions of Red Hat Enterprise Linux of 206,000 subscriptions . at February 29, 2004 . Enterprise subscription revenues increased sequentially by $6.2 million or 35% as compared to Q3 . This compares to a sequential quarterly growth rate of 19% in Q3 .
54 Q4 showed very strong growth in our enterprise technology subscription revenues which increased by $6 .2 million, or 35% as compared to Q3, and increased by $13 .2 million, or 122% as compared to the same prior year quarter . The significant increase in enterprise technologies subscription revenue is being driven by the recognition of revenues from the sales of subscriptions to Red Hat Enterprise Linux in prior quarters and from subscriptions sold in the current quarter . In Q4 we experienced more ratable sales of subscriptions to Red Hat Enterprise Linux across the three months of the quarter than we had in the past which contributed to our Q4 subscriptions revenue growth . We continue to forecast, however, that our subscription sales volume will be rated more heavily in the last 30 days of each quarter .
172. Defendant Thompson predicted the following financial performance for th e
Company in 1 Q05 :
Total revenues in the range of 42 .5 to $43.5 million, which represent a sequential growth rate of 15% to 17 .5% over Q4. Enterprise technology subscription revenues will be in the range of 30.4 to $30.8 million, an increase of 26% to 28%, as compared to Q4. This increase is primarily being driven by the increase in cumulative deployed subscriptions from Red Hat Enterprise Linux as a result of the 87,000 subscription that we sold in the fourth quarter .
173. The next day, March 24, 2004, Red Hat shares traded as high as $22.11 on a trading volume of 42.33 million shares, before closing at $20 .01 per share.
174. On May 14, 2004, the Company filed its Form 10-K for the period ending
February 29, 2004 incorporating the results announced on March 23, 2004 . The Form 10-K was signed by Defendants Thompson and Szulik and contained the same certifications of Defendants
Szulik and Thompson in the 3Q03 Form 10-Q . See ¶1119-120 above).
175. In the Revenue Recognition Section of the Form 10-K, Defendants repeated tha t the Company recognized revenue ratably over the period of the subscription, explaining:
Revenue Recognitio n
We recognize revenue in accordance with Statement of Position No . 97-2, "Software Revenue Recognition" ("SOP 97-2"), as amended by SOP 98-4 and SOP 98-9, Emerging Issues Task Force No . 00-21 ("EITF 00-21') and Staff Accounting Bulletin No . 104 ("SAB 104") depending upon the nature of the arrangement. Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of our sales transactions.
55 Subscription Revenue
Subscription revenue is comprised of enterprise and embedded revenues .
Enterprise subscription revenue is comprised primarily of revenue from sales of Red Hat Enterprise Linux software solutions, however we also generate enterprise subscription revenue from sales of Red Hat Linux, software development tools, technical support and maintenance fees.
During fiscal 2003, we released the first versions of our Red Hat Enterprise Linux offerings, Red Hat Enterprise Linux AS, ES and WS . These technologies are sold under a subscription agreement with specified renewal rates. Our Red Hat Enterprise Linux ("RHEL") products have one and three year base subscription periods. The base subscription entitles the end user to the technology itself and post customer support services (' PCS") consisting of; security errata, updates to the technology, upgrades to new versions of RHEL on a when and if available basis during the term of the subscription, and various levels of Red Hat support. We recognize the revenue from the sale of our Red Hat Enterprise Linux offerings ratably over the period of the subscription . We do not sell the RHEL technology or the components of the PCS that are included in the subscription on a stand alone basis.
We sell Red Hat Enterprise Linux through four channels : distribution, direct sales, original equipment manufacturers ("OEMs") and the web. In the majority of our transactions, subscriptions to Red Hat Enterprise Linux are sold on a stand-alone basis. Our standard subscription term is one year . The revenue associated with the sale of subscription to Red Hat Enterprise Linux is recognized ratably over the period of the end users subscription .
Our subscription agreements with our large enterprise customers sometimes include multiple subscription and/or service elements . These arrangements typically include a subscription to Red Hat Enterprise Linux, Red Hat Network, training services and/or professional consulting. For these contracts, we separate the various elements and recognize revenue attributable to each element in the manner that best matches the delivery of value to our customer . Red Hat Enterprise Linux and Red Hat Network subscription revenues are recognized ratably over the subscription term, training services revenue is recognized when students attend class, and professional services revenue is recognized on a time and materials basis as the services are delivered . When possible, we allocate revenue to each component of the contract based on vendor specific objective evidence ("VSOE") of its fair value. VSOE for our Red Hat Enterprise Linux subscription agreements is created by the fact that we regularly sell RHEL subscriptions on a stand alone basis with renewal rates for year two equal to the amount paid in year one or there is a stated renewal rate in the contract . In contracts where VSOE exists for training or consulting services, such VSOE is demonstrated by either; the ability to purchase additional training or consulting services at specified rates and on a stand alone basis upon expiration of th e
56 original term of the multiple element arrangement or regularly selling the training or consulting services on a stand alone basis at substantially the same rates as those charged in the multiple element arrangement . In certain multiple element arrangements where VSOE cannot be established, the entire value of the contract is recognized ratably over the term of the agreement. Our training and consulting services are not essential to the functionality of Red Hat Enterprise Linux . The majority of our customers purchase subscriptions to Red Hat Enterprise Linux without purchasing any training or consulting services.
In addition, our enterprise subscription revenue is partially derived from sales of our Red Hat Network service offerings. Red Hat Network is an Internet-based set of services to assure the security, availability and reliability of all of our Red Hat software solutions . Red Hat Network is sold in the form of an annual subscription and revenues related to these are recognized ratably over the term of the subscription.
Embedded subscription revenue consists of revenue for technical support and maintenance services provided pursuant to software compiling, debugging and optimization agreements . Revenue is deferred and recognized ratably over the term of the agreement, which is typically 12 months.
176. The 4Q04 and FY04 reported results as follows :
4Q04 Fiscal Year 2004
Total Revenue $36,965,000 $126,084,000
Gross Profit $27,941,000 $91,215,000
Total operating expense $25,407,000 $88,003,000
Income (loss) from operations $2,534,000 $3,212,000
Net Income (loss) $4,997,000 $13,998,000
177. Fueled by the positive earnings releases of December 18, 2003 and March 23 ,
2004, which was reiterated in the Company's Form 10-K filed on May 14, 2004, Red Hat stoc k experienced a tremendous surge in value, reaching its Class Period high of $28 .84 per share on
June 1, 2004.
57 178 . In addition, contained in the Form 10-K was a Report of Independent Auditors by PWC dated May 6, 2004. PWC's report assured investors that the Company conformed with GAAP, and repeated the language in their previous year's report. See ¶138 above) .
J. Reasons for Falsity: 40 and FY 2004
179. Defendants' statements regarding fourth fiscal quarter 2004 results, detailed above in ¶¶168-171 and 174-176, were materially false and misleading , because, as revealed in
Red Hat's Form 10-K/A filed with the SEC on August 4, 2004:
a) Total revenues for fourth fiscal quarter 2004 were actually $36,771,000, not the
$36,965,000 reported;
b) Gross profit for the fourth fiscal quarter 2004 was actually $27,854,000, not the
$27,941,000 reported;
c) Income from operations for the fourth fiscal quarter 2004 was actually
$2,323,000, not the $2,534,000 reported; and
d) Net income for the fourth fiscal quarter of 2004 was actually $4,786,000, not th e
$4,997,000 reported.
180. Defendants ' statements regarding fiscal year 2004 results, detailed above in
¶¶168-171 and 174-176 , were materially false and misleading, because, as revealed in Red Hat' s
Form 10-K/A filed with the SEC on August 4, 2004:
a) Total revenues for fiscal year 2004 were actually $124,737,000, not the
$126,084,000 reported;
b) Gross profit for fiscal year 2004 was actually $90,801,000, not the $91,215,000
reported;
c) Income from operations for fiscal year 2004 was actually $2,946,000, not the
$3,212,000 reported; and
58 d) Net income for fiscal year 2004 was actually $13,732,000 million, not the
$13,998,000 reported .
181 . The statements described above in ¶¶168-171 and 174-176, including PWC' s
Report of Independent Accountants, are materially false and misleading for the reasons stated i n
¶126.
182. Defendant Thompson' s forecasts for 1 Q05 detailed in ¶172 above were materiall y false and misleading, because, as revealed in Red Hat's Form 10-Q filed belatedly with the SEC on July 19, 2004, total revenues were $41,764,000, not in the range of $42 .5 to 43 .5 million forecasted, and enterprise technology subscription revenues were $29,968,000, not in the range of $30.4 to 30.8 million forecasted.
K. Red Hat's June 17, 2004 False Statements
(1) False statements regarding revenue recognition
183 . On June 17, 2004, Red Hat announced its first quarter results for the fiscal quarter ended May 31, 2004, revealing that its revenues of $41 .6 million fell short of the Company' s guidance of$42.5-43. 5 million and consensus expectations of $43 million. In an analyst conference call, Red Hat again issued false statements regarding Red Hat's revenue recognitio n policy, with Red Hat's CFO responding to analysts as follows :
KEVIN THOMPSON, EXEC VP, CFO, RED HAT, INC. :
Enterprise subscription revenues increased by $5 .9 million, or 25%, to $29 .9 million in the first quarter of fiscal 2005 . In Q1, enterprise subscription revenues were slightly lower than we anticipated, as the largest percentage of the subscriptions sold by our direct sales team in North America and EMEA were sold in the last few weeks of the last month of our fiscal quarter . Which reduced the amount of revenues that we recognized from these subscriptions in Q1 . This follows the fourth quarter in which our bookings were very ratable across the quarter.
59 ** *
KATHY EBGERT : You're welcome. Second, revenue was lighter th an guidance at 41 .6 million and I think you said that was because the quarter was very back- end weighted. Is it that some of these 75,000 units or some of the 98,000 units weren't -- the revenue wasn't actually booked at all in this quarter?
KEVIN THOMPSON: Yeah, when you look at the way, uh -- the way our -- our bookings go out across the quarter we really had two issues . One we had a relatively soft March coming out of a very strong February and then had a good April and then a very, very simple May but with a lot of those volumes coming very late in the quarter, so it was very small amount of revenue taken on very -- on a lot of those transactions. So that revenue obviously will -- you know, just a matter of timing so it finds its way into Q2 . I think the other areas is our retail revenues were a little bit soft in the quarter, not a very big number . Uh, and we saw our embedded revenues come down just a little bit as we really shifted our focus as I indicated we signed an agreement with a very large telecommunications equipment manufacturer and we're starting to see Red Hat Enterprise Linux not only through our relations Wind River but also directly begin to be compelling, uh, to these organizations . So we're seeing a shift in the business in that area . ** *
BRENT TRILL, ANALYST, PRUDENTIAL : Thank you. Kevin, your comments about Q1 being more back-end loaded, is it fair to say that some of those deals actually closed early in Q2, they were just a matter of timing on some of the contracts, can you just give us a sense of -- it was only a $900,000 miss, but what was -
KEVIN THOMPSON: Yeah, I think when you look at the -- when you look at the quarter, Brent, and you look at the way we recognize revenue, you know, if you slip, you know, three or four million dollars of bookings out of March into April then you've lost a full month of potentially revenue on -- on those transactions . So, you know, what we saw was that we had a very strong quarter, we had -- actually had the best quarter that we've ever had from Enterprise Linux's perspective obviously which translates into the best quarter we've had in terms of similar value on a booking side of the business, just most of that business on the direct side, and in Europe and in North America in particular, uh, came very, very late in the quarter. And, you know, I can't necessarily tell you all the -- all the trends that created that but we had a -- you know, a number of transactions that were -- we knew they were going to close and they did close they just took longer to close than we thought. And longer to close than what -- than historically, you know, in terms of timing it took to bring them in, but we had a pipeline we had going into the quarter we're pretty confident about the volumes we're going to get to. I think we got way to the high side of the volumes we expected for this quarter and so we had a very strong bookings quarter it just came in a little late .
60 184. On June 17, 2004, Bloomberg News reporter Dina Bass interviewed Defendant
Szulik regarding the timing of the announcement of the resignation of Defendant Thompson .
The interview was broadcast on Bloomberg. During the interview, Defendant Szulik falsel y claimed that the company recognizes revenue from the time it is earned, and not back to th e beginning of the month:
BASS: Now, the market after hours reacted rather negatively to your sales report, why do you think people were as concerned about the sales shortfall, as they were and do you think they have a right to be that concerned ?
SZULIK: No and certainly, they have a right, as you know, to do anything they want but from our perspective it was a very strong quarter and as you look at where some of the shortfall came through it really happened in three areas and two of those areas, which are non-strategic to the company, the decline in retail box sales, the embedded business and the latter part was end of - some end of quarter bookings that came in with our subscription form of revenue recognition had an incremental impact on the total top line number.
BASS: And how did that work? Was that a - you were explaining on the conference call because the contracts were signed a little bit later in the quarter, how did that work?
SZULIK: You know it's interesting, we don't recognize revenue the way a traditional software company does. It's recognized as 100 percent of the revenues when the product is sold, so technically, we have 20 days per month to recognize that revenue, so if a, you know, a product or business is sold, on the 28th or the 29`h of the month, we only have one or two days of which to recognize the revenue for that sale, so in this current quarter - I'm sorry, the Q1 quarter that we just completed, there were one or two contracts that came in that had an impact that only gave us two or three days of revenue recognition but the good news of that of course, is that that sale will show up in deferred revenue, which is - which grew 21 percent quarter-over-quarter, so it catches up to us in the second quarter .
(2) Defendant Szulik lies about the restatement and the SEC
185. In the June 17, 2004, Bloomberg News referred to above, Defendant Szulik also materially misled investors by stating that a restatement and/or SEC investigation was "not happening":
BASS : OK. Now, you reported your earnings for last quarter in a rather unusual fashion this week. After Monday's announcement that Kevin Thompson would be
61 stepping down, your shares declined and then you put out part of the numbers on Tuesday, why do it that way? Why not put out everything on Tuesday, particularly, since based on the information that you gave on Tuesday, you left out sales that you could've extrapolated the sales number out from what you released?
SZULIK: Well, you know, this is - I'm glad that you raised that point because the company has prided itself on transparency, not only in the software code but as part of our overall corporate governance and responsibility and when Kevin made the decision to leave Red Hat ; he wanted to leave on a good quarter. That information, we felt, became material to investors and we communicated it, promptly, to the investment community. What we learned and why we communicated the pre-announcement of the economics because I guess it's a rarity these days that CFO has the option of leaving on his terms when things are going well and what we learned from many analysts, is that they expected negative news, L e. a financial restatement or an SEC investigation because it's quite uncommon that a CFO would leave when things are going well and so, we wanted to reassure investors that that was not hanaenine and more importantly that the health of the business is strong and we think Kevin has done a fantastic job and we wish him all the best and support, in the future .
L. Reasons for Falsity of the June 17, 2004 Statements
186. The statements described above in ¶1183-185 are materially false and misleading for the reasons stated in 1 126 above .
187. Defendant Szulilc's statements in the June 17, 2004 Bloomberg News interview, were materially false and misleading because :
a) Red Hat had been prematurely recognizing revenue from subscriptions for th e previous five years;
b) PWC had already notified Defendants that the Company had to change its revenue recognition methods from a monthly to a daily basis ;
c) As a result of the change in revenue recognition method, the Company would in fact have to restate its financials;
d) Red Hat had already received an inquiry from the SEC regarding its Annual
Report on Form 10-K; and
62 e) Defendant Szulik was fully aware of all of the facts listed above, and knew that a restatement would soon be forthcoming.
IX. DEFENDANT'S ONUSSIONS AND FAILURE TO REVEAL THE TRUT H
188. In addition to the false and misleading statements described in detail throughou t this Complaint, Defendants also failed to disclose the truth regarding Red Hat's financial condition. Specifically, and in addition to the other omissions described in this Complaint,
Defendants failed to tell the public that: a) it was recognizing revenue before it was earned as described throughout this Complaint ; and b) that recognizing revenue ratably over the period of the subscription actually meant that Red Hat was recognizing revenue before the term of the subscription began, and therefore Red Hat's reported financial results were materially false and misleading.
X. DEFENDANTS' FALSE FINANCIAL REPORTING
A. Defendants Violated GAAP
189. At all relevant times during the Class Period, Red Hat represented that thei r financial statements when issued were prepared in conformity with Generally Accepted
Accounting Principles ("GAAP"), which are recognized by the accounting profession and the
SEC as the uniform rules , conventions and procedures necessary to define accepted accounting practice at a particular time. However, in order to artificially inflate the price of Red Hat's stock,
Defendants prematurely recognized revenue in violation of GAAP and SEC reporting requirements to falsely inflate Red Hat's revenues, earnings and earnings per share during the
Class Period.
190. Red Hat's materially false and misleading financial statements resulted from a series of deliberate senior management decisions designed to conceal the truth regarding Red
Hat's actual operating results. PWC, the long time auditors of Red Hat, knew or should hav e
63 known of the accounting manipulations. As a result of the egregious nature of the accounting
fraud, PWC withdrew its audit opinions for the 2002, 2003, and 2004 audits when it issued a new audit report in the restatement for those years .
191 . The magnitude of the amounts by which Red Hat's financial statements wer e materially misstated is not yet fully known. The Company's amended Form 10-K for the fiscal year ending February 29, 2004 includes details of the restatement for the fiscal quarters of 2003 and 2004 and the annual adjustments for fiscal years 2004, 2003 and 2002 . However, according to the Company's July 13, 2004 press release and Form 8-K, the method of recognizing revenue from subscriptions, which the restatement is meant to correct, had been consistently applied for the previous five years . This would include the fiscal years 2001 and 2000, in addition to the fiscal years 2002, 2003 and 2004 . Moreover, the restated 10-K shows that the Company made adjustments to the accumulated deficit account, which indicates that Red Hat made adjustments to prior period income . The Company has not revealed, and Plaintiffs have no way of knowing, what impact the restatement had on results for fiscal years 2001 and 2000, going all the way back to the Company's IPO in August 1999 .
192. As set forth in Statement of Financial Accounting Concepts ("SFAC") No . 1,
Objectives of Financial Reporting by Business Enterprises, one of the fundamental objectives of
financial reporting is that it provide accurate and reliable information concerning an entity's
financial performance during the period being presented .
193. The SEC requires that public companies file quarterly and annual financial
statements that are prepared in conformity with GAAP . SEC Rule 4-01(a) of Regulation S-X
states that "[f]inancial statements filed with the Commission which are not prepared i n
64 accordance with generally accepted accounting principles will be presumed to be misleading or inaccurate." 17 C.F.R. § 210.4-01(a)(1).
194. Management is responsible for preparing fin ancial statements that conform with
GAAP. The AICPA Professional Standards provide :
The financial statements are management's responsibility. . . . Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, record, process, summarize, and report transactions (as well as events and conditions) consistent with management's assertions embodied in the financial statements . The entity's transactions and the related assets, liabilities, and equity are within the direct knowledge and control of management. . . . Thus, the fair presentation of financial statements in conformity with generally accepted accounting principles is an implicit and integral part of management's responsibility.
AU § 110.02 (1998).
195. Generally GAAP provides that revenue should not be recognized until it i s realized or realizable and earned . FASB Statement of Financial Accounting Concepts No . 5,
Recognition and Measurement in Financial Statements of Business Enterprises (December 1984)
("SFAC No.5"), ¶83-84; Accounting Research Bulletin No . 43, Restatement and Revision of
Accounting Research Bulletins (June 1953) Chapter 1A ¶1 ; Accounting Principles Board
Opinion No. 10 Omnibus Opinion, (December 1966), ¶12 .
196. SFAC No . 5, paragraph 83(b) states that "[a]n entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues."
197. SFAC No. 5, Paragraph 84(a) continues "[t]he two conditions (being realized or realizable and being earned) are usually met by the time product or merch andise is delivered or services are rendered to customers , and revenues from manufacturing and selling activities and
65 gains and losses from sales of other assets are commonly recognized at time of sale (usuall y meaning delivery)."
198 . SFAC No. 5, Paragraph 84(d) continues "[i]f services are rendered or rights to use assets extend continuously over time (for example, interest or rent), reliable measures based on contractual prices established in advance are commonly available, and revenues may b e recognized as earned as time passes ."
199 . AICPA Statements of Position 97-2 ("SOP 97-2"), Software Revenue
Recognition, is the GAAP th at governs when revenue should be recognized, and at what amounts, for licensing, selling, leasing, or otherwise marketing computer software . SOP 97-2 supersedes SOP 91-1 and became effective for transactions entered into in fiscal years beginnin g after December 15, 1997. SOP 97-2 provides:
If the arrangement does not require significant production, modification, or customization of software, revenue should be recognized when all of the following criteria are met .
Persuasive evidence of an arrangement exists. • Delivery has occurred. • The vendor's fee is fixed or determinable. • Collectibility is probable.
200. SOP 97-2 further provides, where software arrangements provide multipl e elements, for example, software products, upgrades/enhancements, PCS, or services, the fee should be allocated to the various elements based on vendor-specific objective evidence for fair value. SOP 97-2, Pars 9 and 10 . However:
.12 If sufficient vendor-specific objective evidence does not exist for the allocation of revenue to the various elements of the arrangement, all revenue from the arrangement should be deferred until the earlier of the point at which (a) such sufficient vendor-specific objective evidence does exist or (b) all elements of the arrangement have been delivered. The following exceptions to this guidance are provided . . .
66 If the arrangement is in substance a subscription the entire fee should be recognized ratably (see paragraphs .48 and .49) . . .
.31 Customer Cancellation Privileges. Fees from licenses cancelable by customers are neither fixed nor determinable until the cancellation privileges lapse. Fees from licenses with cancellation privileges expiring ratably over the license period are considered to become determinable ratably over the license period as the cancellation privileges lapse .
.48 As part of a multiple-element arrangement with a user, a vendor may agree to deliver software products currently and to deliver unspecified additional software products in the future . . .
49 The software elements of the kinds of arrangements discussed in paragraph .48 should be accounted for as subscriptions. No allocations of revenue should be made among any of the software products, and all software-product revenue from the arrangement should be recognized ratably over the term of the arrangement beginning with delivery of the first product .
201 . SEC Staff Accounting Bulletin No. 101-Revenue Recognition in Fin ancial
Statements ("SAB 101"), as amended by SAB 104 on December 17, 2003, states that :
The [SEC] staff believes that revenue generally is realized or realizable and earned when all of the following criteria are met :
• Persuasive evidence of an arrangement exists , • Delivery has occurred or services have been rendered , • The seller's price to the buyer is fixed or determinable, and • Collectibility is reasonably assured.
202. SAB 101 provides further guidance on appropriate revenue recognition practices:
4. Fixed Or Determinable Sales Price
A company's contracts may include customer cancellation or termination clauses . Cancellation or termination provisions may be indicative of a demonstration period or an otherwise incomplete transaction . Examples of transactions that financial management and auditors should be aware of and where such provisions may exist include "side" agreements and significant transactions with unusual terms and conditions. These contractual provisions raise questions as to whether the sales price is fixed or determinable . The sales price in arrangements that are cancelable by the customer are neither fixed nor determinable until th e
67 cancellation privileges lapse.6 If the cancellation privileges expire ratably over a stated contractual term , the sales price is considered to become determinable ratably over the stated term .7
203. SEC Staff Accounting Bulletin Topic 13, Revenue Recognition, states that
"revenue should not be recognized until it is realized or realizable and earned ." Specifically,
Topic 13(A)(3)(d) states :
d. License fee revenue
Facts: Assume that intellectual property is physically delivered and payment is received on December 20, upon the registrant's consummation of an agreement granting its customer a license to use the intellectual property for a term beginning on the following January 1 .
Question: Should the license fee be recognized in the period ending December 31 ?
Interpretive Response : No. In licensing and similar arrangements (e .g., licenses of motion pictures, software, technology, and other intangibles), the staff believes that delivery does not occur for revenue recognition purposes until the license term begins . Accordingly, if a licensed product or technology is physically delivered to the customer, but the license term has not yet begun, revenue should not be recognized prior to inception of the license term . Upon inception of the license teen, revenue should be recognized in a manner consistent with the nature of the transaction and the earnings process .
[emphasis added ]
204. Asset forth in Red Hat's February 29, 2004 Form 10-K, Red Hat's policy o n recognition of revenue is stated as follows :
Revenue Recognition: The Company recognizes revenue in accordance with Statement of Position No. 97-2, "Software Revenue Recognition" ("SOP 97-2"), as amended by SOP 98-4 and SOP 98-9, and Staff Accounting Bulletin No . 101 ("SAB 101 ") . Revenue recognition in accordance with these pronouncements c an be complex due to the nature and variability of sales transactions. The Company establishes persuasive evidence of an arrangement for each type of revenue based on either a signed contract with the end customer, a click-through contract on the
6 SAB 101 cites SOP 97-2, ¶31 .
SAB 101 cites SOP 97-2, ¶31 .
68 Company's website, whereby the customer agrees to the Company's standard subscription terms, distribution contracts with OEM's and resellers, or, in the case of individual training seats, through receipt of payment which indicates acceptance of the Company's training agreement terms.
205 . Red Hat recorded revenue from subscriptions on a monthly basis, rather than on a daily basis. The Company used a method that resulted in revenue recognition as if the subscription commenced on the first day of the month in which the subscription was sold . For example, the Company would have recognized one-twelfth of the revenue of a twelve-month subscription in the calendar month during which the subscription commenced, and the remaining subscription revenue over the next eleven calendar months.
206. During the Class Period, Defendants knowingly and intentionally booked an d reported material amounts of revenue, in violation of GAAP, including SOP 97-2. Defendants did so by deliberately, or at least severely recklessly, employing an accounting manipulation in which they prematurely recognized revenue from subscription agreements on a monthly basis, rather than a daily basis, which resulted in revenue recognition as if the subscription commenced on the first day of the month in which the subscription was sold. Defendants knew or should have known that revenue was improperly recognized as evidenced by the plethora of meetings at which the Company' s financial condition were discussed .
207. The press releases, conference calls wi th analysts and filings with the SEC detailing "record" financial results detailed above in Section VIII were materially false and misleading because Red Hat's financial results during the Class Period were artificially inflated due to Defendants' improper revenue recognition practices.
208 . Defendants were required to cause the Company to disclose, in its periodic filings with the SEC, financial statements , and news releases the existence of the material facts described herein and to appropriately recognize and report income in conformity with GAAP .
69 Defendants failed to cause the Company to make such disclosures and to account for and to report income in conformity with GAAP .
209. Due to the non-disclosures and non-GAAP accounting, the above particularized documents which Defendants caused the Company to disseminate to the investing public during the Class Period were materially false and misleading.
210. Defendants knew and ignored, or were reckless in not knowing, the facts which indicated that the above particularized press releases, public statements, and filings with the SEC which were disseminated to the investing public during the Class Period, were materially false and misleading for the reasons set forth above.
B. Red Hat's Financial Restatement
211 . The fact that Red Hat restated is an admission that (1) the publicly-issued financial statements for each of the restated periods were not prepared in conformity with
GAAP; (2) that they materially misrepresented Red Hat's and the Company' s financial condition and results of operations ; and (3) that the financial statements reported during the Class
Period were incorrect based on information available to Defendants at the time the results were originally reported
212. Under GAAP, a restatement of previously issued fin ancial statements is the most serious step, reserved only for circumstances where no lesser remedy is available . As recently noted by the SEC, "GAAP only allows a restatement of prior financial statements based upon information `that existed at the time the financial statements were prepared,"' and "restatements should not be used to make any adjustments to take into account subsequent information that did not and could not have existed at the time the original financial statements were prepared ."
213. Accounting Principles Board ("APB") Opinion No . 20, Accounting Changes, provides that restatements are only permitted, and are required, to correct material accountin g
70 errors or irregularities that existed at the time the financial statements were prepared. APB 20 has defined the kind of "errors" that may be corrected through a restatement: "Errors in financial statements result from mathematical mistakes , mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time that the financial statements were prepared." See APB 20 ¶'j7-13.
214. By restating its own financial statements, Red Hat admitted that each document publishing the original financial statements contained an untrue statement of material fact . The
Company's restatement is an admission that each of the annual and quarterly reports on Form
10-K and Form 10-Q for the fiscal years 2002, 2003 and 2004, as well as the first fiscal quarter
2005 ended May 31, 2004, that were filed with the SEC contained untrue statements of material fact. Similarly, by restating, the Company also conceded that each of the press release s disseminated to the investing public and other statements referred to in Section VIII above, contained untrue statements of material fact .
215 . Indeed, Red Hat's massive restatement was not due to a simple mathematical error, honest misapplication of a standard or oversight . Instead, the restatement was due to intentional misuse of the facts known at the time the financial statements were prepared and issued to the investing public .
216. The SEC has recently reiterated its position that, in its investigations of restated financial statements, it often finds that the persons responsible for the improper accounting acted with scienter :
[T]he Commission often seeks to enter into evidence restated financial statement, and the documentation behind those restatements, in its securities fraud enforcement actions in order, inter alia, to prove the falsity and materiality of the original financial statements [and] to demonstrate that persons responsible for the original misstatements acted with scienter . ..
71 In re Sunbeam Sec. Litig., No. 98-8258-Civ.- Middlebrooks (S .D. Fla. filed Jan 31, 2002) (SEC
Amicus Curiae Brief Regarding Defendants' Motion In Limine to Exclude Evidence of the restatement and Restatement Report).
217. The restatements at issue in this case contain several indicators of scienter :
(a) The type of restatement (misuse of the facts) - The restatement at issue was due to blatant misuse of the facts. As alleged below, in many instances, Red Hat either knew what the correct accounting treatment was, and ignored it, or recklessly turned a blind eye to the information they had.
(b) The size of the restatement -Red Hat's net income originally reported for the third quarter 2003 (November 30, 2002) in the amount of $214,000 was restated to a loss of $789,000, change of over 468% .
(c) The duration over which the improper accounting was perpetrated - The revenue recognition method corrected by the restatement had been utilized for five years.
(d) The time period restated - As more fully detailed herein, Red Hat restated over three years of financial statements to correct fraudulent accounting for fiscal years 2002, 2003 and 2004, as well as first fiscal quarter 2005, and the restatement and change in revenue recognition method impacted the previous two fiscal years, 2001 and 2000.
(e) The types of accounting manipulations employed - As detailed herein the improper accounting corrected by this restatement did not occur as a result of good faith differences in accounting judgments, or interpretations of complicated or vague accounting rules . The accounting rules and precepts violated by Red Hat were long established, basic accounting standards and concepts, such as the most basic rule of recording revenue in the period it was actually incurred .
218. The improper accounting was not a result of inexperienced accounting manager s who did not understand accounting rules, nor can it be blamed solely on poor accounting controls. To the contrary, Red Hat's financial officers knew what they were doing . They were experienced CPA's and seasoned financial professionals with significant accounting, auditing and SEC reporting experience . For example, Defendant Thompson worked at Arthur Anderson and PWC prior to his tenure at Red Hat . Defendant Thompson, as a result of his "Big Six"
72 accounting and auditing background, was well versed in evaluating, establishing, and auditin g accounting policies, practices and internal accounting controls .
219. Tellingly, Defendants in this case did not themselves discover their "error" and report it while re-reviewing earlier facts and rush to come forward . Instead, they were caught b y their new outside auditor partner at PWC, and forced to restate. (See ¶¶88-90 and 101 above) .
C. Defendants ' Additional GAAP Violations
220. In addition to the GAAP and SEC violations desc ribed above, the Company also violated several additional fundamental GAAP principles :
The principle that interim financial reporting should be based upon th e same accounting principles and practices used to prepare annual financial statements wa s violated (APB No. 28, ¶10);
ii. The principle that financial reporting should provide information that i s useful to present and potential investors and creditors and other users in making rationa l investment , credit and similar decisions was violated (FASB CON No. 1, ¶34);
iii. The principle that financial reporting should provide information about the economic resources of an enterprise, the claims to those resources, and effects of transactions, events and circumstances that change resources and claims to those resources was violate d
(FASB CON No. 1, ¶40);
iv. The principle that financial reporting should provide information abou t how management of an enterprise has discharged its stewardship responsibility to owners
(stockholders) for the use of enterprise resources entrusted to it was violated. To the extent that management offers securities of the enterprise to the public, it voluntarily accepts wider responsibilities for accountability to prospective investors and to the public in general (FASB
CON No. 1, 150);
73 v. The principle that financial reporting should provide information about an enterprise's financial performance during a period was violated. Investors and creditors often use information about the past to help in assessing the prospects of an enterprise. Thus, although investment and credit decisions reflect investors ' expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past
enterprise performance (FASB CON No. 1, ¶42);
vi. The principle that financial reporting should be reliable in that it represents what it purports to represent was violated . That information should be reliable as wel l as relevant is a notion that is central to accounting (FASB CON No. 2, ¶158-59);
vii. The principle of completeness, which means that no information is omitted that may be necessary to ensure that the Financial Statements validly represent underlying events and conditions, was violated (FASB CON No . 2, ¶79); and
viii. The principle that conservatism be used as a prudent reaction t o
uncertainty in order to ensure that uncertainties and risks inherent in business situations ar e
adequately considered was violated. The best way to avoid injury to investors is to try to ensure
that what is reported represents what it purports to represent (FASB CON No . 2, ¶¶95, 97) .
221 . Further, the undisclosed adverse information concealed by Defendants during th e
Class Period is the type of information that, because of SEC regulations, regulations of the
national stock exchanges and customary business practice, is expected by investors and securities
analysts to be disclosed and is known by corporate officials and their legal and financial advisors
to be the type of information that is expected to be and must be disclosed.
M. PWC'S AUDITING VIOLATIONS
222. The auditing standard of care is established by principles and standards
recognized and accepted by the accounting profession. As certified public accounts and auditors,
74 PWC and Barber are charged with knowledge of, and must comply with, these principles and standards known as Generally Accepted Auditing St andards ("GAAS") and GAAP. PWC and
Barber are also charged with knowledge of, and must comply with all applicable law, including , but not limited to, SEC rules and regulations.
223 . As one of the largest audit firms in the world, PWC was well aware of the strategies, methods and procedures required by GAAS to conduct a proper audit. Also, PWC and Barber knew of the audit risks inherent at Red Hat and the industry in which Red Hat operated because of the comp rehensive services it provided to Red Hat, over the years and its experience in the computer software/technology indust ry.
224. GAAS are promulgated by the American Institute of Certified Public Accountants
("AICPA") and embody ten standards, which concern an auditor's professional qualities and the judgment to be exercised in the performance of the auditor' s examination and report. The GAAS standards include General Standards, Field Work Standards, and Reporting Standards as follows :
• General Standards
• Training and Proficiency - requiring adequate training and proficiency as an auditor .
• Independence - requiring independence in mental attitude by auditor.
• Due Care - requiring due professional care to be exercised in planning and performing the audit and in preparing the audit report.
• Fieldwork Standards
• Planning and Supervising - requiring audit work to be properly planned and any assistants to be supervised .
• Internal Control - requiring sufficient understanding of the audited entity's internal control in order to plan the audit and determine tests to be performed.
75 • Evidential Matter - requiring sufficient competent evidence to be obtained by auditor through inspection, observation, inquiry and confirmation to afford a reasonable basis for audit opinion.
• Reporting Standards
• GAAP - requiring auditors' report to state whether financial statements are presented in accordance with generally accepted accounting principles.
• Consistency - requiring auditor to identify deviations from accounting principles applied in previously audited period .
• Disclosure - requiring informative disclosures in audited financial statements to be reasonably adequate.
• Reporting Obligation - requiring an expression of the auditor's opinion of financial statements, or an assertion that an opinion cannot be expressed and the reason.
225. These ten auditing standards provide the professional framework for the
Statement on Auditing Standards (SAS), promulgated by the Auditing Standards Board (ASB) o f the AICPA. Auditors are required by the SEC, and under the AICPA Code of Professional
Conduct, to comply with these standards .
226. GAAP are promulgated by the Financial Accounting Standards Board and embody the conventions , rules and procedures necessary to define accepted accounting practices at a particular time . Additional GAAP based standards and principles governing accountancy include: Financial Accounting St andards ("FAS"); FAS Interpretations; and Accounting
Principles Board ("APB") Opinions. PWC and Barber are required to know and apply GAAP to meet their professional obligations to Red Hat.
227 . Financial audits, such as those PWC and Barber were retained to conduct for Re d
Hat, require the verification of information contained in Red Hat's financial statements throug h the examination of underlying accounting records and other audit evidence. PWC and Barber, as auditors, were required to follow GAAS to determine whe ther Red Hat's financial statements
76 fairly presented Red Hat's financial position and results of operation , including a determination of whether the financial statements are presented in accordance with GAAP.
228. PWC and Barber were required to audit Red Hat 's financial statements in accordance with GAAS, and report the audit results to Red Hat , the board of directors, the audit committee and the members of the investing public, including Plaintiffs and the other member s of the Class.
229. On May 29, 2003, Red Hat filed its 2003 annual report on Form 10-K for the fiscal year ended February 28, 2003 ("the 2003 Form 10-K") . The 2003 Form 10-K included
PWC's unqualified audit report dated March 25, 2003, which falsely represented that PWC had conducted its audit for Red Hat 's year end 2003 financial statements in accordance with GAAS, and that Red Hat's financial statements conformed with GAAP :
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders' equity, and of cash flows present fairly, in all material respects, the financial position of Red Hat, Inc. and its subsidiaries at February 28, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended February 28, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management ; our responsibility is to express an opinion on these financial statements based on our audits . We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion .
230. PWC and Barber issued unqualified audit opinions on Red Hat's fin ancial statements for fiscal year end financial statements for fiscal years 2000, 2001, 2002, 2003 and
77 2004, which falsely represented that PWC had conducted its audits in accord ance with GAAS, and that Red Hat's fin ancial statements conformed with GAAP.
231 . Contrary to the statements in its audit report, PWC and Barber did not perform its fiscal years 2000 through 2004 audits in accordance with GAAS, and the financial statements were not in conformity with GAAP.
232. PWC and Barber possessed knowledge or were severely reckless in not possessing knowledge of that Red Hat was prematurely recognizing revenue and that this was not in compliance with GAAP. PWC and Barber failed to design audit procedures to test revenue, net income and EPS more extensively than originally planned, or heighten its scrutiny in its audit to obtain greater assurances that Red Hat's revenue net income and EPS were accurately stated . These actions greatly enhanced and facilitated Red Hat ' s fraudulent and unlawful scheme to overstate revenue, net income and EPS as alleged herein .
233 . With knowledge of Red Hat's true financial condition, or in reckless disregard thereof, PWC certified the materially false and misleading financial statements of Red Hat and provided unqualified Independent Auditors' Reports, which were included in the companies' SEC filings and publicly disseminated statements. Without these materially false and misleading unqualified audit opinions and reports, the fraud alleged above could not have been perpetrated .
234. The pervasiveness of the fraud involving Red Hat's premature recognition o f revenue (more than five years) ; the requirement that PWC and Barber independently review and test the Company's revenue; and the rarity of such a vast restatement and corresponding withdrawal of PWC's audit opinions all provide evidence that PWC and Barber knew and/or severely recklessly disregarded that its Class Period statements and omissions were materially false and misleading .
78 235. PWC and Barber knew or recklessly disregarded that Red Hat's financial
statements were materially false and misleading during the Class Period because Red Ha t prematurely recognized revenue from subscriptions on a monthly basis, in violation of GAAP and SEC rules .
236. PWC and Barber's intentional or severely reckless failure to comply with GAAS and PWC and Barber' s performance on the Red Hat audits rose to the level of severe recklessness and/or knowing fraud .
A. PWC and Barber's Violations of GAAS
237. PWC and Barber represented in unqualified audit opinions in connection wi th the filing of Red Hat's Forms 10 -K that the audits were performed in a manner consistent wi th
GAAS. Such representations were materially false, misleading and without reasonable basis.
PWC and Barber's breach of GAAS is evidenced, in part, by its withdrawal of its unqualified audit opinions for the 2002, 2003 and 2004 fiscal year audits .8
0 AU Section 561, "Subsequent Discovery of Facts Existing at the Date of the Auditor's Report" sets forth the implications of PWC's withdrawal of its unqualified audit opinion:
.05 When the subsequently discovered information is found both to be reliable and to have existed at the date of the auditor's report, the auditor should take action in accordance with the procedures set out in subsequent paragraphs if the nature and effect of the matter are such that (a) his report would have been affected if the information had been known to him at the date of his report and had not been reflected in the financial statements and (b) he believes there are persons currently relying or likely to rely on the financial statements who would attach importance to the information. With respect to (b), consideration should be given, among other things, to the time elapsed since the financial statements were issued.
.06 When the auditor has concluded, after considering (a) and (b) in that action should be taken to prevent future reliance on his report, he should advise his client to make appropriate disclosure of the newly discovered facts and their impact on the financial statements to persons who are known to be currently relying or who are likely to rely on the financial statements and the related auditor's report. When
79 238. PWC and Barber knew or were severely reckless in not knowing that fraudulent activities by Red Hat resulted in the Company's financial statements contravening provisions of
GAAP. This is evidenced by : (1) the close relationship between PWC and Red Hat ; (2) Red
Hat's statement in the July 13, 2004 press release that Red Hat's financial information for fiscal years 2002, 2003 and 2004, and the first fiscal quarter of 2005 would be restated ; and (3) PWC's withdrawal of its unqualified audit opinions for the 2002, 2003 and 2004 fiscal year audits of
Red Hat.
the client undertakes to make appropriate disclosure, the method used and the disclosure made will depend on the circumstances .
a. If the effect on the financial statements or auditor's report of the subsequently discovered information can promptly be determined, disclosure should consist of issuing, as soon as practicable, revised financial statements and auditor's report. The reasons for the revision usually should be described in a note to the financial statements and referred to in the auditor's report . Generally, only the most recently issued audited financial statements would need to be revised, even though the revision resulted from events that had occurred in prior years .
b. When issuance of financial statements accompanied by the auditor's report for a subsequent period is imminent, so that disclosure is not delayed, appropriate disclosure of the revision can be made in such statements instead of reissuing the earlier statements pursuant to subparagraph (a) .
c. When the effect on the financial statements of the subsequently discovered information cannot be determined without a prolonged investigation, the issuance of revised financial statements and auditor's report would necessarily be delayed . In this circumstance, when it appears that the information will require a revision of the statements, appropriate disclosure would consist of notification by the client to persons who are known to be relying or who are likely to rely on the financial statements and the related report that they should not be relied upon, and that revised financial statements and auditor's report will be issued upon completion of an investigation . If applicable, the client should be advised to discuss with the Securities and Exchange Commission, stock exchanges, and appropriate regulatory agencies the disclosure to be made or other measures to be taken in the circumstances.
80 239. PWC and Barber also breached 7 of the 10 required GAAS standards, to-wit: (a)
1 st General Standard - by failing to maintain their independence; (b) 3`h General Standard - by failing to exercise due professional care in the planning and performance of Red Hat audit and in the preparation of PWC's audit reports; (c) is` Standard of Fieldwork - by negligently planning and supervising Red Hat audits; (d) 3`l Standard of Fieldwork - by failing to obtain through inspection, observation , inquiries and confirmations competent evidential matter to afford a reasonable basis for audit opinions on the financial statements; (e) 1st Standard of Reporting - by reporting that Red Hat's financial statements were presented in accordance with GAAP; (f) 3'd
Standard of Reporting - by failing to determine whether informative disclosures in financial statements were reasonably adequate ; and (g) 4th Standard of Reporting - by issuing unqualified audit reports on materially misstated financial statements.
240. Additionally, AU 316 paragraph 23 states that Sec tion 319 entitled
"Consideration of Internal Control in a Financial Statement Audit," requires the auditor to obtain a sufficient understanding of the entity's internal control over financial reporting to pla n the audit. It also notes that such knowledge should be used to identify types of potential misstatements, consider factors that affect the risk of material misstatement and design substantive tests . The understanding will affect the auditor's consideration of the significance o f fraud risk factors . In addition, when considering the significance of fraud risk factors, the auditor may wish to assess whether there are specific controls that mitigate the risk or whether specific control deficiencies may exacerbate the risk .
241 . Under AU 316 paragraph 27, judgments about the risk of material misstatement due to fraud may affect the audit in the following ways:
• Professional skepticism. Due professional care requires the auditor to exercise professional skepticism - that is, an attitude that includes a
81 questioning mind and critical assessment of audit evidence . Some examples demonstrating the application of professional skepticism in response to the auditor's assessment of the risk of material misstatement due to fraud include (a) increased sensitivity in the selection of the nature and extent of documentation to be examined in support of material transactions ; and (b) increased recognition of the need to corroborate management explanations or representations concerning material matters - such as further analytical procedures, examination of documentation or discussion with others within or outside the entity .
• Accounting principles and policies . The auditor may decide to consider further management's selection and application of significant accounting policies, particularly those related to revenue recognition, asset valuation, or capitalizing versus expensing . In this respect, the auditor may have a greater concern about whether the accounting principles selected and policies adopted are being applied in an inappropriate manner to create a material misstatement of the financial statements.
242. Some examples of responses to the auditor' s assessment of the risk of material misstatements arising from fraudulent financial reporting are set forth in AU 316: paragraph 17:
(a) Riskfactors relating to management's characteristics and influence over the control environment. Examples include -
• A motivation for management to engage in fraudulent financial reporting. Specific indicators might include -
-- A significant portion of management's compensation represented by bonuses, stock options or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position, or cash flow.
-- An excessive interest by management in maintaining or increasing the entity's stock price or earnings trend through the use of unusually aggressive accounting practices.
-- A practice by management of committing to analysts, creditors, and other third parties to achieve what appear to be unduly aggressive or clearly unrealistic forecasts.
82 • A failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. Specific indicators might include - * *
-- Domination of management by a single person or small group without compensating controls such as effective oversight by the board of directors or audit committee.
-- Inadequate monitoring of significant controls .
-- Management failing to correct known reportable conditions on a timely basis .
243. AU 316, paragraph 30 provides:
• Revenue recognition. If there is a risk of material misstatement due to fraud that may involve or result in improper revenue recognition, it may be appropriate to confirm with customers certain relevant contract terms and the absence of side agreements - inasmuch as the appropriate accounting is often influenced by such terms or agreements . For 'example, acceptance criteria, delivery and payment terms and the absence of future or continuing vendor obligations, the right to return the product, guaranteed resale amounts, and cancellation or refund provisions often are relevant in such circumstances .
244. SAS No. 61 (AU Sec. 380), Communication with Audit Committees, states that
"the auditor should determine that the audit committee is informed about the process used by management in formulating particularly sensitive accounting estimates and about the basis for the auditor's conclusions regarding the reasonableness of those estimates ." Additionally, SAS
No. 61 "requires auditors of Securities and Exchange Commission (SEC) clients to discuss with audit committees the auditor's judgments about the quality, and not just the acceptability, of the company's accounting principles and underlying estimates in its financial statements ."
245. APB 20 provides that, where a company misjudges an estimate for accounting purposes, the misjudgment should be corrected prospectively through a charge to revenues .
Conversely, a restatement is required where the company committed an "error ." An "error" in
83 financial statements results from "mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared ." FAS 16 calls such restatements "rare in modern financial accounting."
246. PWC and Barber violated GAAS and the standards set forth in SAS No. 1 and
SAS No. 53 by, inter alia, failing to adequately plan their audit and properly supervise the work of assistants and to establish and carry out procedures reasonably designed to search for and detect the existence of errors and irregularities that would have a material effect upon the financial statements.
247. PWC and Barber violated GAAS Standard of Field Work No . 2, which requires the auditor to make a proper study of existing internal controls, including accounting, fin ancial and managerial controls, to determine whether reliance thereon was justified, and, if such controls are not reliable, to expand the nature and scope of the auditing procedures to be applied.
The standard provides that a sufficient understanding of an entity's internal control structure be obtained to adequately pl an the audit and to determine the nature , timing and extent of tests to be performed. AU § 150.02. In all audits, the auditor should perform procedures to obtain a sufficient understanding of three elements of an entity's internal control structure: the control environment ; the accounting system; and control procedures. AU § 319.02.
248. As a result of its failure to accurately report on Red Hat's fiscal 2000 through
2004 and first fiscal quarter 2005 financial statements, PWC and Barber utterly failed in their role as an auditor as defined by the SEC . SEC Accounting Series Release No . 296,
Relationships Between Registrants and Independent Accountants, Securities Act Release No .
6341, Exchange Act Release No . 18044, states in part :
84 Moreover, the capital formation process depends in large part on the confidence of investors in financial reporting. An investor's willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest . The quality of information disseminated in the securities markets and the continuing conviction of individual investors that such information is reliable are thus key to the formation and effective allocation of capital. Accordingly, the audit function must be meaningfully performed and the accountants' independence not compromised . The auditor must be free to decide questions against his client's interests if his independent professional judgment compels that result .
249. PWC 's and Barber's opinions, which represented that Red Hat's fiscal years 2000 through 2004 fi nancial statements were presented in conformity with GAAP, were materiall y false and misleading because PWC and Barber knew or were severely reckless in not knowing that Red Hat's financial statements violated the principles of fair reporting and GAAP.
250. PWC and Barber knew or severely recklessly disregarded facts indicating that they should have: (a) disclaimed or issued adverse opinions on Red Hat fiscal 2000 through 2004 fiscal year end financial statements ; or (b) withdrawn, corrected or modified its opinions for fiscal years 2000 through 2004 to recognize Red Hat improper accounting and financial reporting as described above.
B. PWC Violated Section 1OA(b)(1) of the Exchange Ac t
251. During the time of the conduct described above, Section IOA(b)(1) of th e
Exchange Act provided in relevant part:
If, in the course of conducting an audit . . ., the independent public accountant detects or otherwise becomes aware of information indicating that an illegal act (whether or not perceived to have a material effect on the financial statements of the issuer) has or may have occurred, the accountant shall, in accordance with generally accepted accounting standards . . . determine whether it is likely that an illegal act has occurred ; and if so, determine and consider the possible effect of the illegal act on the financial statements of the issuer . . . and as soon as practicable, inform the appropriate level of the management of the issuer and assure that the audit committee of the issuer, or the board of directors . . . in the absence of such a committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of such
85 accountant in the course of the audit, unless the illegal act is clearly inconsequential .
252. PWC knew or was severely reckless in not knowing that Red Hat improperly recognized revenue, as described in ¶1189-210 above .
C. PWC Violated Its Own Accounting Guidelines
253. In addition to violating the formal rules regulating accounting, PWC's participation in the revenue recognition scheme violates its own internal procedures . In Section
2.17 of PWC's Software Revenue Recognition -- User-Friendly Guide, it clearly states that "in no circumstances should revenue be recognized prior to the commencement to the initial license period." Moreover, the guide states that this is consistent with SAB 101, as well as TPA 5100.70
(which is the AICPA's Technical Practice Aids section entitled "Effect of Commencement of an
Initial License Term and Software Revenue Recognition") .
D. PWC and Barber Eneaged in Improper Professional Conduct Within the Meanine of Commission Rule of Prac tice 102(e)
254. An auditor is required to exercise professional skepticism when performing audit procedures and gathering and analyzing audit evidence . AICPA Codification of Statements on
Auditing Standards ("AU") Section 230.07.
255 . Based on the foregoing, in connection with its audit of Red Hat's year end financial statements, PWC and Barber failed to maintain the attitude of professional skepticism required by GAAS concerning Red Hat's accounting for revenue. PWC and Barber did not follow up on the materiality of the non-GAAP revenue recognition method of accounting that
PWC and Barber were aware that Red Hat used. Furthermore, PWC and Barber accepted
uncorroborated representations of Red Hat's management in lieu of performing additional audit
procedures, in contravention of AU Section 33 .
86 256. For example, in the Management Representation Letters, management represente d that GAAP had been applied in the preparation of the financial statements for each year end fo r the fiscal years 2000 through 2004 . However, as described above, this representation was contradicted by other audit evidence PWC and Barber obtained .9 PWC and Barber failed to maintain their professional skepticism .
257. In addition, in conducting an audit, an auditor must obtain sufficient competen t evidential matter through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit. AU Sections
150.02 & 326.01 .
258. Based on the foregoing, in connection with Red Hat's fiscal year end 2000 through 2004 financial statements , PWC and Barber failed to obtain sufficient competent evidence (including sufficient management representations) in support of Red Hat's accounting for revenue recognition for its licensing of software .
259. Auditors must also exercise due professional care in performing the audit and preparing the audit report. AU Sections 150.02 and 230.01 .
260. In connection with the audit of Red Hat's 2000 through 2004 fiscal year en d financial statements, PWC and Barber failed to exercise due professional care by failing to plan and perform audit procedures necessary to afford a reasonable basis for PWC's audit opinions.
As described above, PWC and Barber were well aware of Red Hat's Non-GAAP method of revenue recognition reported in Red Hat's financial statements.
9 "[R]epresentations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion regarding the financial statements under audit ." AU Section 333 .02.
87 261 . Despite PWC's and Barber's awareness of the non-GAAP revenue recognition and other information that could materially impact the financial statements, PWC and Barber failed to perform sufficient audit procedures to assess properly whether Red Hat's accounting fo r revenue recognition was in conformi ty with GAAP. As a result, Red Hat improperly recognized non-GAAP revenue and, as described above, misused it to materially inflate earnings for the fiscal years 2000 through 2004, as well as first fiscal quarter 2005.
262. In conducting an audit, an auditor is required to state in the auditor's repo rt whether, in the auditor's opinion, the financial statements are presented in all material respects in conformity with GAAP . AU Sections 410 and 411. An auditor may express that the financial statements are presented in conformity with GAAP only when the auditor has formed such an opinion on the basis of an audit performed in accord ance with GAAS. AU Section 508 .07.
263 . Based on the foregoing , in connection with the audit of Red Hat's fiscal year ends
2000 through 2004 financial statements, PWC and Barber failed to render an accurate audit report when they stated that Red Hat' s financial statements had been prepared in conformity with
GAAP and the audit had been performed in accordance with GAAS . In fact, the financial statements were not in conformity with GAAP, and the audit was not performed in accordance with GAAS.
264. The failures of Barber, a PWC engagement partner and managing partner of
PWC's Raleigh, North Carolina office, to comply with GAAS in the conduct of the audit bind and are imputed to PWC .
E. PWC's Lack of Independenc e
265. Section 13(a) of the Exchange Act requires that financial statements filed with the
Commission be certified by "independent accountants ." Rule 13a-1 specifically requires issuers to file annual reports containing financial statements certified by independent public accountants .
88 Regulation S-X under the Exchange Act sets forth, among other things, the requirements
applicable to audited financial statements included in periodic reports filed by an issuer pursuant
to Section 13 of the Exchange Act . Rule 2-02(b)(1) of Regulation S-X requires an auditor's
report to state, "whether the audit was made in accordance with generally accepted auditing
standards [GAAS] ." Consistent with the Commission's rules and pronouncements, GAAS
requires auditors to maintain strict independence from their audit clients . Statement on Auditing
Standards ("SAS") No .1 explains the independence requirement as follows :
It is of utmost importance to the profession that the general public maintain confidence in the independence of independent auditors . Public confidence would be impaired by evidence that independence was actually lacking, and it also might be impaired by the existence of circumstances which reasonable people might believe likely to influence independence. To be independent, the auditor must be intellectually honest; to be recognized as independent, he must be free from any obligation to or interest in the client, its management or its owners . . . . Independent auditors should not only be independent in fact ; they should avoid situations that may lead outsiders to doubt their independence . 266. Rule 2-01(b)(1) of Regulation S-X, in effect during the relevant period, states tha t
"[t]he Commission will not recognize any certified public accountant or public accountant who is
not in fact independent." To determine whether auditors are independent for purposes of GAAS, the Commission looks to the AICPA rules, among other things. SAS No. 1 provides that the
independence rules ofthe AICPA Code of Professional Conduct "[h]ave the force of professional
law for the independent auditor."
267. Annual and quarterly reports filed by issuers under Section 13(a) of the Exchange
Act, and Rules 13a-1 and 13a-13 thereunder, must accurately reflect the financial condition and
operating results of the issuer. Rule 12b-20 further requires the inclusion of any additional
material information that is necessary to make required statements, in light of the circumstances
under which they were made, not misleading . Section 13(b)(2)(A) of the Exchange Act requires
issuers to "make and keep books, records, and accounts, which, in reasonable detail, accuratel y
89 and fairly reflect the transactions and dispositions of the assets ofthe issuer." Section 13 (b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit the preparation of fin ancial statements in conformity with GAAP and to maintain the accountability of assets .
268. In each of the instances described above , PWC and Barber lacked the requisite independence with respect to Red Hat. This conduct constituted improper professional conduct within the meaning of Rule 102(e)(1)(iv)(A). PWC and Barber failed to comply with Rule 2-
02(b)(1) of Regulation S-X by issuing audit reports stating that the audits were done in accordance with GAAS, when, in fact, PWC and Barber lacked the requisite independence when the audits were performed .
XII. DEFENDANTS REAPED ENORMOUS FINANCIAL BENEFITS THROUGH THEIR FRAUDULENT SCHEME
A. Defendants Acted With Scienter
269. In addition to the other reasons alleged in this Complaint, Defendants acted with scienter (with knowledge and/or intent) in that Defendants knew that the public documents and statements issues or disseminated in the name of the Company were materially false and misleading; knew that such statements or documents would be issued or disseminated to the investing public; and knowingly and substantially participated or acquiesced in the issuance or dissemination of such statements or documents as primary violations ofthe federal securities laws. As set forth elsewhere herein in detail , Defendants, by virtue of their receipt of information reflecting the true facts regarding Red Hat , their control over, and/or receipt and/or modification of Red Hat's allegedly materially misleading misstatements and/or their
90 associations with the Company which made them privy to confidential proprietary information concerning Red Hat, participated in the fraudulent scheme alleged herein .
270. Defendants knew and/or recklessly disregarded the falsity and misleading nature of the information which they caused to be disseminated to the investing public . The ongoing fraudulent scheme described in this complaint could not have been perpetrated over a substantial period of time, as has occurred, without the knowledge and complicity of the personnel at the highest level of the Company, including the Individual Defendants and Red Hat's auditor PWC.
271 . Defendants had the motive and opportunity to perpetrate the fraudulent scheme and course of business described herein for the following reasons :
a) The scheme allowed the Individual Defendants to collectively reap approximately
$94,055,651 through the sale of almost 6 million shares of Red Hat common stock at artificially inflated prices;
b) The scheme enabled Red Hat to raise $600 million dollars through the sale of low interest convertible debentures ;
c) The scheme permitted Red Hat to acquire storage infrastructure software company Sistina Software, Inc . for $31 million, using its artificially inflated stock price as currency;
d) The accounting machinations in which Defendants engaged (i.e., improper recognition of revenue from subscription contracts, which was the Company's primary revenue source, to boost revenue in the reporting periods in which the contracts were entered) constitutes a practice that could only have been deliberately instituted with knowledge or reckless disregard that revenues, net income, and operating profits would be artificially inflated by reporting that
91 more revenue had been earned in the quarter in which the subscription contract was entered than actually was the case; and
e) The Individual Defendants were the most senior officers of Red Hat, issued statements and press releases on behalf of Red Hat and had the opportunity to commit the fraud alleged in this Complaint .
B. Defendants' Insider Selling Was Unusual In Timing And Amoun t
272 . In addition to the indicators of scienter discussed above, and throughout this complaint, the scienter of the Red Hat Defendants is further evidenced by the massive amount of insider trading during the Class Period, which is both particularly unusual, and highly suspicious, in timing and amount. A chart depicting Defendants' pre-Class Period and Class Period sales is attached hereto as Exhibit A.
273 . Defendant Szulik engaged in both pre-Class Period and Class Period transactions , but his sales during the Class Period are staggering in comparison . Szulik's pre-Class Period transactions, from January 1, 2000 to December 16, 2002, amounted to 213,826 shares being sold for proceeds of $5,048,883, consisting of 2 .76% of his total holdings. This amount is but a fraction of Szulik's Class Period transactions: 2,899,800 shares sold for proceeds of $43,597,194 between the period of December 17, 2002 and July 12, 2004, consisting of 30 .32% of his total holdings. This equates to over ten times the number of shares sold prior to the Class Period.
Even more suspicious is the fact that most of Szulik's class-period transactions took place in
February of 2004 - just one month before the Fiscal Year 2005 was to begin, which was the time period the new auditor would be reviewing .
274. As a result of the upcoming PWC auditor rotation, Szulik began to unload his shares of Red Hat onto the unsuspecting investing public. During the month of February alone,
Szulik unloaded over 1 .2 million shares of Red Hat stock, reaping proceeds of approximatel y
92 $22 million. Moreover, Szulik's trading in the month of February, 2004 comprises more than
halfof Szulik's $44 million Class Period sales, with sales on almost every day of the month
amounting to proceeds of $22,110,094 .
275. The same general pattern of February sales can be demonstrated for Defendant s
Thompson, Cormier and Webbink . Defendant Thompson, who joined the company in
September 2000, did not make an y trades before the Class Period. However, during the Class
Period, he sold 135,000 shares for proceeds of $2,910,450 .10 These sales represent 23.35% of
his total holdings, and take place between January of 2004 and April of 2004, thus immediately
proceeding the dreaded mandatory auditor rotation.
276. Cormier, who joined Red Hat one month prior to the beginning of the Class
Period, also sold shares during the Class Period, just months before the PWC auditor rotation
was scheduled to take place, selling 80,000 shares for proceeds of $1,771,720 . Cormier sold
21 .75% of holdings during the Class Period.
277. Webbink engaged in very few pre-Class Period transactions, only selling 908
shares for proceeds of $4,222, representing a mere 1 .95% ofhis holdings. These trades pale in comparison to Webbink's Class Period transactions , when he sold 215,706 shares for proceeds of
$3,701,360. These sales amount to 76.00% of his holdings. In particular, Webbink sold most of his shares between January 9, 2004 and May 24, 2004, selling 129,706 shares of Red Hat stock
for proceeds of approximately $3.1 million.
10 Lead Plaintiff has reason to believe that Thompson sold an additional 190,000 shares during the class period, which would bring his total to 325,000 shares sold for proceeds of $4,375,000 . However, as Lead Plaintiff could not verify these trades with an SEC Form 4, they were not included. These unverified trades indicate that Thompson sold 42 .31 % of his Red Hat stock during the class period .
93 278 . A similarly large pattern of class-period transactions can be demonstrated with
Defendant Buckley' s transactions . Buckley's pre-class transactions amounted to only 985,000 shares sold for proceeds of $10,111,665, with 23.70% of his holdings sold, compared t o
2,667,240 shares sold for proceeds of $42,074,927 during the Class Period - three times as many shares sold during the Class Period." In fact, according to the 2004 Proxy Statement filed
August 13, 2004, Buckley has sold 100% of his shares during the Class Period and holds n o remaining stock in Red Hat.
279. Defendants Szulik, Buckley, Thompson, Webbink, and Cormier collectively sol d close to 6 million shares of Red Hat stock during the Class Period for proceeds of approximatel y
$94,055,651 without revealing the adverse facts known to them concerning Red Hat's busines s and prospects, as are described in this Complaint. A summary of their insider sales is illus trated on the chart below:
Red Hat, INC. SUMMARY OF PRE-CLASS PERIOD SALES vs. CLASS PERIOD INSIDER SALES Insider Shares Sold Proceeds Shares Sold Proceeds Pre-Class During Pre - Durine Class During Class Period Class Period Period Period Matthew Szulik 213,826 $5,048,883 2,899,800 $43,597,194
Timothy Buckley 985,000 $10,111,665 2,667,240 $42,074,927
Kevin Thompson 0 $0 135,000 $2,910,450
Mark Webbink 908 $4,222 215,706 $3,701,360
Paul Cormier 0 $0 80,000 $1,771,720
11 Lead Plaintiff has reason to believe that Buckley sold an additional 317,800 shares during the class period, which would bring his total to 325,000 shares sold for proceeds of $4,375,000. However, as Lead Plaintiff could not verify these trades with an SEC Form 4, they were not included.
94 280. Even within Red Hat, high-level employees were shocked and dismayed at the astonishing level and timing of insider trading, as well as the timing of the sales in relation to the news of the restatement. For example, the Former Red Hat Independent Contractor Principal
Consultant/Program Manager said that that even before the public announcements regarding the impending earnings restatements, it was "not a secret" within Red Hat that the Company's senior executives, including Szulik, Buckley, and General Counsel Webbink, sold "many millions" of dollars of their personal holdings in Red Hat . He said that these significant stock sales did not
"sit right" with him or with his Red Hat colleagues .
281 . Other employees recognized the unabashed dumping of the Individual Defendant s personal holdings as well . The Former Director of Professional Services said that when the
Company had an audit partner rotation in 2004, it was highly likely that the "fun and games" were going to stop, and, in the witness' view, Thompson saw the writing on the wall, and decided that it was "time to bail." In addition, the Former Regional Account Manager remembered that senior management's attempts to cut their respective financial losses in light of the announcement that was coming often served as fodder for discussion amongst the Red Hat staff. Finally, the Former Inside Account Executive summed it up by saying that Szulik was there to "rape that Company and then he'll bail out" and the shareholders would be left holding the bag.
282. Particularly twisted was the fact that while these insiders reaped millions i n profits, emails encouraging the staff not to sell their Red Hat stock were regularly disseminated by Red Hat's senior management. The Former Regional Account Manager said that these email communications consistently asserted that Red Hat staff would be unwise to sell their stock in the Company, as the stock's valuation was expected to continually increase. The emails insisted
95 that Red Hat's stock was on target to "be at $80 someday ." The witness recalled that he and his
colleagues wondered aloud as to why it was that members of Red Hat's senior management were
actively selling such large percentages of their holdings in the Company if the stock was on
target to hit $80 per share.
283 . This highly suspicious and outrageous selling of Red Hat stock by high-level Re d
Hat insiders who knew what effect the auditor rotation could have on the company is even
further evidence that each of the Individual Defendants was aware that the Company's revenue
recognition scheme could be exposed, setting off a chain of events which could devastate the
value of their holdings by tens of millions of dollars.
C. The Defendants ' Compensation. Bonuses, and Other Incentives were Highly Dependent on Meeting Red Hat 's Aggressive Financial Obiectives and Estimates
284. According to Red Hat's 2001, 2002, and 2003 Proxy Statements, "[a]n
executive's total compensation package includes a cash salary and bonus determined by the
compensation committee, long-term incentive compensation in the form of stock options and
various benefits." As highlighted in the Company's 2004 Proxy Statement, bonus "[p]ayouts are
based on a combination of Company performance, including revenue and earnings targets, and
the achievement of individual goals and objectives ." This bonus policy provided Defendants
with a great incentive to meet their numbers . For instance, during fiscal year 2004, according to
the 2004 Proxy Statement, "the Company performance was below internal target levels, and
therefore executives were eligible to receive below target bonuses under the VC Plan . During
fiscal 2003, the Company did not meet internal minimum performance levels and therefore
executives were not eligible for bonus payments under the VC Plan ."
285 . Moreover, as evidenced below, a large part of Defendants' compensation was in the form of underlying stock options, and thus was directly tied to the performance of Red Ha t
96 stock. This gave Defendants a great incentive to meet analysts' estimates and keep revenues high at any cost.
(1) Defendant Szulik
286. Defendant Szulik's compensation, according to Red Hat's 2001,2002,2003 an d
2004 Proxy Statements, was "based upon the Company's overall performance, the perform ance of his management team , the compensation paid by competing companies and the Company's prospects, among other objectives and subjective factors, including the achievement of perform ance targets in accordance with the Company's executive compensation policies ."
According to the Company's 2001 Proxy Statement, during fiscal year 2001 , Defendant Szulik's salary was $233,771, with a $152,312 bonus and 1,000,000 underlying securities options.
During fiscal year 2002, according to the Company's 2004 Proxy Statement, Defendant Szulik's salary was $350,000, with a $72,500 bonus and 2,000,000 underlying securities options. In addition, according to the 2004 Proxy Statement, Defend ant Szulik's salary in fiscal year 2003 was $350,000 with 1,000,000 underlying securities options, and in fiscal year 2004 was
$350,000, with a $174,675 bonus and 1,000,000 underlying securities options.
287. Defendant Szulik is also a party to an incentive stock option agreement and a non- qualified stock option agreement, providing for the lapsing in full of Red Hat's repurchase right as to any unvested option shares upon Defendant Szulik's termination of employment . In fiscal year 2002, according to the Company's 2002 Proxy Statement, Defendant Szulik received
$3,860,000 in restricted stock awards, which were the result of 1,000,000 shares purchasable for
$.50 per share. According to the Company's 2003 Proxy Statement, "[flair market value on the date of the grant was $4.36 per share. As of 2/28/03, fair market value was $5 .89 per share and the aggregate value is $5,390,000 . 125,000 shares vest each quarter over a period of thre e years."
97 288. In addition to participation in the normal executive compensation "VC Plan",
Defendant Szulik was eligible to earn up to $100,000 upon the achievement of certain strategic objectives. Defendant Szulik in fact satisfied these objectives and earned the additional
$100,000 for fiscal year 2004 .
289. According to the Company's 2003 Proxy Statement, Red Hat entered into a n
Employment Agreement with Defendant Szulik effective July 24, 2002 . Defendant Szulik's
"arrangement includes an annual salary of $350,000, subject to increase, annual incentive cash bonus equal to the greater of $200,000 or fifty percent of his salary as well as annual stock option awards of at least 500,000 shares which shall vest in equal amounts on a quarterly basis over a four year period following the date of grant ." In addition, during fiscal year 2004,
Defendant Szulik was granted 500,000 stock options at an exercise price of $6 .80 as an incentive to encourage Defendant Szulik to continue his service as CEO. The compensation committee also determined that an additional stock option grant to purchase 500,000 shares at an exercise price of $.50 would be "a suitable means of providing additional incentive" to Defendant Szulik .
(2) Defendant Thompson
290. According to the Company's 2001 Proxy Statement, during fiscal year 2001 ,
Defendant Thompson's salary was $93,625, with a $49,063 bonus and 350,000 securities underlying options. During fiscal year 2002, according to the Company's 2002 Proxy Statement,
Defendant Thompson's salary was $250,000 with a $55,567 bonus and 500,000 underlying securities options . In addition, according to the Company's 2004 Proxy Statement, Defendant
Thompson's salary in fiscal year 2003 was $250,000 with 100,000 underlying securities options, and in fiscal year 2004 was $250,000, with a $59,172 bonus and 100,000 underlying securities options.
98 291 . During fiscal year ending February 28, 2001, according to Red Hat's 2001 Proxy
Statement, Defendant Thompson received a $200,000 relocation advance, which was non- interest bearing and forgiven ratably over four years, provided Defendant Thompson remained with Red Hat. Of this advance, according to the Company's yearly Proxy Statements, $29,167 was forgiven during fiscal year 2001, $50,000 during fiscal year 2002, $50,000 during fiscal year
2003, and $50,000 during fiscal year 2004 . As of February 29, 2004, Defendant Thompson owed Red Hat $20,833 of this relocation expense .
(3) Defendant Buckley
292. According to the Company's 2001 Proxy Statement, during fiscal year 2001,
Defendant Buckley's salary was $188,333, with a $226,875 bonus and an additional 200,000 underlying securities options. During fiscal year 2002, according to the Company's 2002 Proxy
Statement, Defendant Buckley's salary was $250,000, with a $30,000 bonus. In addition, according to the Company's 2004 Proxy Statement, Defendant Buckley's salary in fiscal year
2003 was $250,000 and in fiscal year 2004 was $188,500, with a $71,006 bonus . Defendant
Buckley, like Defendant Szulik, was a party to an incentive stock option agreement and a non- qualified stock option agreement, which provided for the lapsing in full of Red Hat's repurchase right as to any unvested option shares upon the termination of his employment.
(4) Defendant Webbink
293 . According to the Company's 2001 Proxy Statement, during fiscal year 2001 ,
Defendant Webbink's salary was $110,518, with a $35,938 bonus and 100,000 underlying securities options. During fiscal year 2002, according to the Company's 2002 Proxy Statement,
Defendant Webbink's salary was $185,000, with a $25,875 bonus and 225,000 underlying securities options. In addition, according to the Company's 2004 Proxy Statement, Defendant
Webbink's salary in fiscal year 2003 was $185,000, with 50,000 underlying securities options ,
99 and in fiscal year 2004 was $185,000, with a $ 33,582 bonus and 50,000 underlying securities options.
(5) Defendant Cormier
294. During fiscal year 2002, according to the Company's 2002 Proxy Statement ,
Defendant Conmier's salary was $225,112, with a $10,000 bonus and 425,000 underlying securities options. According to the Company's 2004 Proxy Statement, Defendant Cormier's salary in fiscal year 2003 was $275,000, with 100,000 underlying securities options, and in fiscal year 2004 was $275,000, with a $56,172 bonus and 100,000 underlying securities options .
D. Defendants Were Motivated To Inflate Red Hat Stock In Order To Complete StockBased Acquisitions During The Class Period
295. Defendants were further motivated to conceal the adverse facts detailed herein i n order to acquire other companies using Red Hat's artificially inflated shares. On December 18,
2003, Red Hat announced that it had entered into an Agreement and Plan of Merger on
December 17, 2003, under which a wholly-owned subsidiary of Red Hat would merge with and into Sistina Software, Inc. ("Sistina"), with Sistina as the surviving entity . Under the agreement,
Red Hat acquired all outstanding common stock of Sistina in exchange for the issuance of
1,979,874 shares of Red Hat stock and the assumption of all outstanding Sistina stock options valued, in aggregate, at $30 .7 million. The transaction closed on December 23, 2003 .
296. Although the Sistina acquisition was the only acquisition completed during th e
Class Period, Defendants acquired several other companies before and after the Class Period . In a December 18, 2003 conference call with analysts, Defendant Thompson shared Defendants' intent to pursue other acquisition opportunities. In addition, the proceeds from a private placement during the Class Period were also intended for acquisitions, as explained in a January
6, 2004 press release.
100 E. Defendants Propped Up the Company 's Stock Price In Order to Complete a Sale of $600 Million in Convertible Senior Debentures
297 . Defendants also concealed the adverse facts detailed herein in order to complete a private placement of $600 million of Convertible Senior Debentures bearing an interest rate of
0.50% per annum, payable each January 15 and July 15, beginning on July 15, 2004. Defendants announced the private placement of $400 million in convertible senior debentures in a press release dated January 5, 2004. When the private offering commenced on January 12, 2004, it had increased to $600 million . According to the Company's January 6, 2004 press release, Red
Hat "expect[ed] to use the net proceeds for general corporate purposes, including possible acquisitions of complementary businesses and technologies and the expansion of its international operations." On May 11, 2004, the Company filed an initial Registration Statement allowing the purchasers of the $600 Convertible Senior Debentures to, from time to time, resell their debentures and the shares of common stock issuable upon conversion of the debentures . That
Registration Statement ultimately became effective August 18, 2004 . Had the truth been known about the Company's revenue recognition policy, the private debt placement would not have been possible at such favorable terms .
F. Defendant's Had Access to an Enormous Amount of Detailed Financial Information at Their Fingertips
298. A wide array of detailed accounting and financial information was constantly available to the Individual Defendants. With the availability and use of these systems, reports, and meetings each of the Individual Defendants were privy to current, updated, and detailed accounting and financial information at all times .
(1) Red Hat utilized accounting software
299. According to the Former Senior Staff Accountant, aDM "dashboard" system (a tool whereby managers learn of key performance information, which is updated continuousl y
101 with streaming/real-time data, in order to monitor and manage the key risk indicators and key performance indicators that characterize critical aspects of business performance) was used to obtain current real-time accounting information regarding the Company's financial standing . In
addition, the witness said Red Hat's financial information was also maintained within an Oracle
Ili CRMProject Accounting package, which Defendant Thompson used to get information on the company's financial condition at any time .
(2) Regular internal reports were given directly to management
300. The Individual Defendants also periodically and regularly received and reviewe d
detailed financial reports which were generated internally at Red Hat . As the Former Director of
Professional Services explained, all of the information regarding Red Hat's financial standing
and accounting records was available and broken down within Red Hat Director of Operations
Mandeep Chaddha's Core Office Reports . Therefore, he confirmed that Red Hat management
always had information regarding the Company's financial standing and accounting records at its
disposal. The witness also said he knew that Red Hat's internal revenue reports were in fact
updated on at least a monthly basis, possibly a weekly basis.
(3) The Finance Department held regular meetings
301 . On top of all this information, Red Hat's finance department periodically held
accounting meetings . The Former Senior Staff Accountant personally attended regular
accounting meetings that were held by Senior Finance Manager Bart Kalsu, Senior Vice
President of Revenue Accounts William Tendel, and, at times, Defendant Thompson . He stated
that these accounting meetings were held monthly, or sometimes every other month .
G. The Individual Defendants Controlled All Aspects of Red Hat
302. Moreover, according to the Former Managing Consultant/Director of Professional
Services, Defendants Szulik and Thompson controlled "every single aspect" of Red Hat' s
102 business, in that they "made all the decisions ." According to this former employee, almost no decision "about anything" could be made at Red Hat without Defendants Szulik and/or
Thompson's personal approval, and that "everything flowed up" with little or no delegation of authority. Moreover, if any Red Hat employee questioned anything that Defendants Szulik or
Thompson did, "that person disappeared, fast." The Former Director of Business Intelligence corroborated this, saying Defendant Szulik knew "everything about everything" that had to do with Red Hat and its operations, and that he was involved with "every little thing at Red Hat ."
(1) Defendant Szulik
303 . According to the Former Director of Business Intelligence, Defendant Szulik wa s very involved in all aspects of Red Hat's adoption and implementation of the subscription model and the processes associated with Red Hat's subscription renewals. In fact, according to this former employee, Defendant Szulik regularly met with "anybody and everybody" and was constantly involved in debate regarding Red Hat's renewal rates. Defendant Szulik also reportedly held regular `reverse sessions" to address and explore any and all issues associated with the subscription renewal rates . According to the former Director of Business Intelligence,
Defendant Szulik's knowledge regarding Red Hat's vulnerability in terms of renewal rates, as well as his involvement in the day-to-day operations at Red Hat "is a given ."
(2) Defendant Thompson
304. The Former Field Services Representative confirmed that Defendant Thompso n had direct knowledge of the Company's subscription renewal forecasts . According to the
Former Regional Account Manager, Red Hat sales personnel forecasted how many accounts were likely to renew for a given period . This information was put into Excel spreadsheets, after which the sales managers rolled up the subscription contract renewal forecasts and rolled the reports up to Defendant Thompson directly. In addition, according to the Former Director o f
103 Professional Services, Defendant Thompson knew that Red Hat had an established history of manipulating its revenues in order to achieve its quarterly revenue goals, and that the problem in fact spanned beyond the Company's policy of recognizing 1/12 of its contractu al revenue on the last day of a given month end .
(3) Defendant Webbink
305. As Red Hat's General Counsel , Defendant Webbink had signi ficant control and input into Red Hat's operations. As the Former Director of Professional Services confirmed,
Defendant Webbink was generally involved in "everything" in association with Red Hat's operations . The Former Business Development Manager said that for "some time," Defendant
Webbink was required to sign off on all customer contracts . He stated that Defendant Webbink's signature was definitely required in "all legal matters" and that there was no doubt that
Defendant Webbink was regularly "involved" in Red Hat's operations from a legal standpoint .
The Former Director of Professional Services also confirmed that for "quite some time,"
Defendant Webbink signed off on "all customer contracts, big and small ." He stated that
Defendant Webbink's office was "right next to Thompson's" and that the two had a "visual" of each other throughout the day. He also stated that there was no question that Webbink was a regularly interacting "peer" to Szulik and Thompson at Red Hat, and that there was no doubt that
Defendant Webbink was Red Hat's "final counsel for the Corporation ."
(4) Defendant Buckley
306. As Red Hat's Senior Vice President and Chief Operating Officer, Defendant
Buckley had significant control and input into Red Hat's operations .
(5) Defendant Cormier
307. As Red Hat's Red Hat's Executive Vice President of Engineering, Defendant
Cormier. The Former Business Development Manager said Cormier's role was to "ge t
104 involved" whenever there were problems/issues that arose with large customer accounts . The
Technical Account Manager clarified this further, stating that Defendant Cormier was "not just a crisis manager," and was involved in Red Hat's customer management outside of just "dealing with problems."
H. Defendant PWC Had Siviificant Financial Incentives to Appease Red Hat 308. As reported on Red Hat's Proxy statements, Defendant PWC has been handsomely compensated throughout their engagement with Red Hat . For instance, Defendant
PWC was paid $1,068,554 and $846,651 in fiscal years ending February 28, 2001, and February
28, 2002, respectively.
309. During the Class Period, according to Red Hat's Proxy Statement filed June 12,
2003, Defendant PWC was paid $413,435 in fees for the fiscal year ending February 28, 2003, and $681,070 in fees for fiscal year ending February 29, 2004. These fees are quite large, especially considering the fact that PWC's office in Raleigh is very small.
XIII. CLASS ACTION ALLEGATION S
310. Plaintiffbrings this action as a federal class action pursuant to Federal Rules o f
Civil Procedure 23(a) and (b)(3) on behalf of a class (the "Class"), consisting of all those who purchased the securities of Red Hat between December 17, 2002 and July 12, 2004 inclusive,
(the "Class Period") and who were damaged thereby. Excluded from the Class are Defendants, the officers and directors of the Company, members of their immediate families and their legal representatives, heirs, successors or assigns and any entity in which Defendants have or had a controlling interest .
311 . The members of the Class are so numerous that joinder of all members is impracticable. Throughout the Class Period, Red Hat securities were actively traded on the
NASDAQ National Market. While the exact number of Class members is unknown to Plaintiff
105 at this time and can only be ascertained through appropriate discovery, Plaintiff believes that there are hundreds or thousands of members in the proposed Class .
312 . Plaintiff's claims are typical of the claims of the members of the Class, because plaintiff and all of the Class members sustained damages arising out of Defendants' wrongful conduct complained of herein .
313. Plaintiff will fairly and adequately protect the interests of the Class members an d has retained counsel who is experienced and competent in class actions and securities litigation .
314. A class action is superior to all other available methods for the fair and efficien t adjudication of this controversy, since joinder of all members is impracticable . Furthermore, as the damages suffered by individual members of the Class may be relatively small, the expense and burden of individual litigation make it impossible for the members of the Class t o individually redress the wrongs done to them . There will be no difficulty in the management of this action as a class action.
315 . Questions of law and fact common to the members of the Class predominate ove r any questions that may affect only individual members, in that Defendants have acted o n grounds generally applicable to the entire Class . Among the questions of law and fact common to the Class are:
a) Whether the federal securities laws were violated by Defendants' acts as alleged herein;
b) Whether the Company's publicly disseminated press releases and statements during the Class Period omitted and/or misrepresented material facts;
c) Whether Defendants breached any duty to convey material facts or to correc t material facts previously disseminated ;
106 d) Whether the Defendants acted willfully, with knowledge or recklessly, in omitting and/or misrepresenting material facts ; and
e) Whether the members of the Class have sustained damages and, if so, what is the appropriate measure of damages.
XIV. APPLICABILITY OF PRESUMPTION OF RELIANCE : FRAUD ON THE MARKET DOCTRINE
316. Plaintiffs will rely, in part, upon the presumption of reliance established by th e fraud-on-the-market doctrine in that, among other things :
a) Defendants made public misrepresentations or failed to disclose facts during th e
Class Period;
b) The omissions and misrepresentations were material ;
c) Red Hat securities traded in an efficient market ;
d) The misrepresentation alleged would tend to induce a reasonable investor to misjudge the value of the Company' s securities; and
e) Plaintiff and other members of the Class purchased Red Hat securities betwee n the time Defendants misrepresented or failed to disclose material facts and the time the true facts were disclosed, without knowledge of the misrepresented or omitted facts .
317. At all relevant times, the market for Red Hat securities was an efficient market for the following reasons, among others :
a) Red Hat securities were listed and actively traded during the Class Period on th e
NASDAQ exchange, an open, highly efficient and automated market . The average daily volume of the Red Hat common stock during the Class Period was 3,518,357 shares . The total number of shares traded during the Class Period was 1,382,714,429 shares ;
107 b) As a regulated issuer, Red Hat regularly made public filings, including its Forms
10-K, Forms 10-Q and related press releases, with the SEC;
c) Red Hat was followed by analysts from major brokerages including America's
Growth Capital ; Banc of America Securities; Cans & Company; C.E. Unterberg Towbin ; CIBC
World Markets ; Citigroup Smith Barney; Credit Suisse First Boston; Decatur Jones Equity
Partners, LLC ; Deutsche Bank Securities, Inc.; First Albany ; Goldman, Sachs & Co.; Jefferies and Company; IMP Securities; JP Morgan Chase ; McDonald Investments ; Midwest Research;
Pacific Crest Securities ; Prudential Financial ; Robert W . Baird & Co . ; SG Cohen & Co .
Spellman Research; SunTrust Robinson Humphrey ; Susquehanna Financial Group ; Thomas
Weisel Partners; USB Investment Research ; Wachovia Capital Markets, LLC ; and WR
Hambrecht & Co. The reports of these analysts were redistributed to the brokerages' sales force, their customers, and the public at large ; and
d) Red Hat regularly communicated with public investors via established market communication mechanisms, including the Company's website, regular disseminations of press releases on the major news wire services, and other wide-ranging public disclosures, such as communications with the financial press and other similar reporting services .
318. As a result, the market for Red Hat securities digested current informatio n regarding the Company from the publicly available sources described above and reflected such information in the prices of Red Hat's securities. As would be expected where a security is traded in an efficient market, material news concerning Red Hat's business had an immediate effect on the market price of Red Hat's securities, as evidenced by the rapid decline in the market price in the immediate aftermath of Red Hat's corrective disclosures as described herein . Under these circumstances, all purchasers of Red Hat's securities during the Class Period suffere d
108 similar injury due to the fact that the price of Red Hat securities was artificially inflated throughout the Class Period. At the times they purchased or otherwise acquired Red Hat's securities, Lead Plaintiff and other members of the Class were without knowledge of the facts concerning the wrongful conduct alleged herein and could not reasonably have discovered those facts. As a result, the presumption of reliance applies . Plaintiffs will also rely, in part, upon the presumption of reliance established by a material omission .
COUNT I
VIOLATION OF SECTION 10(b) OF THE EXCHANGE ACT AND RULE 10b 5 PROMULGATED THEREUNDER (AGAINST ALL DEFENDANTS)
319. Lead Plaintiffs repeat and reiteratess the allegations set forth above as though fully set forth herein . This claim is asserted against all Defendants .
320. During the Class Period, Defendants carried out a plan, scheme and course o f conduct which was intended to and, throughout the Class Period which did : (a) deceive the investing public, including Lead Plaintiffs and other Class members, as alleged herein ; (b) artificially inflate and maintain the market price of Red Hat's publicly traded securities ; and (c) cause Lead Plaintiffs and other members of the Class to purchase Red Hat's publicly traded securities at artificially inflated prices . In furtherance of this unlawful scheme, plan and course of conduct, Defendants took the actions set forth herein . Defendants are sued as primary participants in the wrongful and illegal conduct charged herein.
321 . In addition to the duty of full disclosure imposed on Defendants as a result o f their making of affirmative statements and reports, or participation in the making of affirmative statements and reports to the investing public , they each had a duty to promptly disseminate truthful information that would be material to investors in compli ance with the integrated disclosure provisions of the SEC as embodied in SEC Regulation S-X (17 C .F.R. § 210.01 et
109 seq.), S-K (17 C .F.R. § 229.10 et seq.) and other SEC regulations, including accurate and truthful information with respect to Red Hat's operations, financial condition and performance so that the market prices of the Company's publicly traded securities would be based on truthful, complete and accurate information.
322. Defendants, individually and in concert, directly and indirectly, by the use, means or instrumentalities of interstate commerce and/or of the mails, engaged and participated in a continuous course of conduct to conceal adverse material information about the business, business practices, performance, operations and future prospects of Red Hat as specified herein .
323. These Defendants employed devices, schemes and artifices to defraud, while in possession of material adverse non-public information and engaged in acts, practices, and a course of conduct as alleged herein in an effort to assure investors of Red Hat's value an d performance and continued substantial growth, which included the making of, or the participation in the making of, untrue statements of material facts and omitting to state material facts necessary in order to make the statements made about Red Hat and its business operations and future prospects in the light of the circumstances under which they were made, not misleading, as set forth more particularly herein, and engaged in transactions, practices and a course of business which operated as a fraud and deceit upon the purchasers of Red Hat's securities during the Class Period.
324. As a result of the dissemination of the materially false and misleading informatio n and failure to disclose material facts, as set forth above, the market price of Red Hat's securities were artificially inflated during the Class Period. In ignorance of the fact that market prices of
Red Hat's publicly traded securities were artificially inflated, and relying directly or indirectly on the false and misleading statements made by Defendants, or upon the integrity of the market in
110 which the securities trade, and/or on the absence of material adverse information that was known to or recklessly disregarded by Defendants but not disclosed in public statements by Defendants
during the Class Period, Lead Plaintiffs and the other members of the Class acquired Red Hat
securities during the Class Period at artificially high prices and were damaged thereby .
325. At the time of said misrepresentations and omissions, Lead Plaintiffs and other
members of the Class were ignorant of their falsity, and believed them to be true . Had Lead
Plaintiffs, the other members of the Class and the marketplace known of the true performance,
business practices, future prospects and intrinsic value of Red Hat stock, which were not
disclosed by Defendants, Lead Plaintiffs and other members of the Class would not have
purchased or otherwise acquired their Red Hat publicly traded securities during the Class Period,
or, if they had acquired such securities during the Class Period, they would not have done so at
the artificially inflated prices which they paid .
326. By virtue of the foregoing, Defendants have each violated Section 10(b) of the
Exchange Act, and Rule 1 Ob 5 promulgated thereunder.
327. As a direct and proximate result of Defendants' wrongful conduct, Lead Plaintiffs
and the other members of the Class suffered damages in connection with their respective
purchases and sales of the Company's securities during the Class Period.
COUNT II
VIOLATION OF SECTION 20(a) OF THE EXCHANGE ACT (AGAINST SZULIK, THOMPSON, WEBBINK . BUCKLEY AND CORMIER)
328. Lead Plaintiffs repeat and reiterate the allegations set forth above as if set forth
fully herein. This claim is asserted against the Individual Defendants .
329. Defendants Szulik, Thompson, Webbink, Buckley and Cormier each acted as a
controlling person of Red Hat within the meaning of Section 20(a) of the Exchange Act a s
111 alleged herein . By virtue of their high level positions with the Company, participation in and/or awareness of the Company's operations and/or intimate knowledge of the Company's actual performance, these Defendants had the power to influence and control and did influence an d control, directly or indirectly, the decision making of the Company, including the content and dissemination of the various statements which Lead Plaintiffs contend are false and misleading.
Each of these Defendants was provided with or had unlimited access to copies of the Company' s reports, press releases, public filings and other statements alleged by Lead Plaintiffs to b e misleading prior to and/or shortly after these statements were issued and had the ability t o prevent the issuance of the statements or cause the statements to be corrected .
330. In addition, each of these Defendants had direct involvement in the day to da y operations of the Company and, therefore, is presumed to have had the power to control o r influence the particular transactions giving rise to the securities violations as alleged herein, an d exercised the same .
331 . As set forth above, Red Hat and these Defendants each violated Section 10(b) and
Rule IOb-5 by their acts and omissions as alleged in this Complaint. By virtue of their controlling positions, these Defendants are liable pursuant to Section 20(a) of the Exchange Act .
As a direct and proximate result of these Defendants' wrongful conduct, Lead Plaintiffs and other members of the Class suffered damages in connection with their purchases of the
Company's securities during the Class Period.
COUNT Ill - VIOLATION OF SECTION 304 OF SARBANES-OXLEY
332. Lead Plaintiffs repeat and reiterate the allegations set forth above (other than the paragraphs in Counts I & II) as if set forth fully herein. This claim is asserted against
Defendants Szulik and Thompson.
112 333 . As described herein, Red Hat has restated its audited financial statements for the fiscal years ended February 28, 2002, February 28, 2003, and February 29, 2004, and its unaudited financial statements for the fiscal quarter ended May 31, 2004 . Red Hat was required to prepare this accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with the financial reporting requirements under the securities laws as described herein.
334. Pursuant to the Sarbanes-Oxley Act of 2002, Pub . L. No. 107-204, Title III,
§ 304, 116 Stat . 778, codified at 15 U.S.C. § 7243, Red Hat's CEO (Defendant Szulik) and CFO
(Defendant Thompson) are required to reimburse Red Hat for -- (1) any bonus or other incentive- based or equity-based compensation received by Defendant Szulik or Defendant Thompson from
Red Hat during the 12-month period following the first public issuance or filing with th e
Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of Red Hat securities during that
12-month period.
XV. REQUEST FOR RELIEF
WHEREFORE, Lead Plaintiffs requests a judgment, as follows :
a) Determining that this action is a proper class action, and certifying proposed class representatives under Rule 23 of the Federal Rules of Civil Procedure;
b) Awarding compensatory damages in favor of Lead Plaintiffs and the other Class members against all Defendants, jointly and severally, for all damages sustained as a result of
Defendants' wrongdoing, in an amount to be proven at trial, including interest thereon ;
c) Pursuant to Section 304 of the Sarbanes-Oxley Act of 2002, 15 U .S.C. §7243, require Red Hat's CEO (Defendant Szulik) and CFO (Defendant Thompson) to reimburse Red
Hat for (1) any bonus or other incentive-based or equity-based compensation received b y
113 Defendant Szulik or Defendant Thompson from Red Hat during the 12-month period followin g the first public issuance or filing with the Commission (whichever first occurs) of the financia l document embodying such financial reporting requirement ; and (2) any profits realized from the sale of Red Hat securities during that 12-month period .
d) Awarding Lead Plaintiffs and the Class their reasonable costs and expense s incurred in this action, including counsel fees and expert fees;
e) Such other and further relief as the Court may deem just and proper .
XVI. JZJRY TRIAL DEMANDED
Lead Plaintiffs hereby demand a trial by jury.
114 Dated: May 5, 2005 Respectfully submitted,
THEE TEND & WEBB LAW FIRM By. Rufus Edmisten North Carolina Bar No . 1289 William Woodward Webb North Carolina Bar No . 4624 133 Fayetteville Street Mall, Suite 300 P.O. Box 1509 Raleigh, North Carolina 27602 Tel : (919) 831-8700 Fax : (919) 831-8749
Local Counsel for Lead Plaintiff The Union Group
MILBERG WEISS BERSHAD & SCHULMAN LLP Maya Saxena Fla. Bar No. 0095494 [email protected] Christopher S. Jones Fla. Bar No. 0306230 cjones@milbergweiss .com Kristi Stahnke McGregor Fla. Bar No. 0732931 [email protected] S . Melisa Twomey Fla. Bar No. 0872571 mtwomey@milbergweiss .com 5200 Town Center Circle Tower One, Suite 600 Boca Raton, FL 33486 Tel: (561) 361-5000 Fax : (561) 367-8400
Lead Counsel for Lead Plaintiff The Union Group
115 CERTIFICATE OF SERVICE
I HEREBY CERTIFY a copy of the foregoing CONSOLIDATED AMENDED CLASS ACTION COMPLAINT was e-mailed to the following counsel on May 5, 2005 :
Jeffrey B. Rudman Robert J. Kopecky E-mail: [email protected] E-mail : [email protected] William H. Paine Stacey G. Pagonis E-mail : [email protected] E-mail : [email protected] WILMER CUTLER PICKERING HALE AND KIRKLAND & ELLIS LLP DORR LLP 200 East Randolf Drive 60 State Street Chicago, IL 60601 Boston, MA 02109 Counsel for Defendant PricewaterhouseCoopers Counsel for Defendants Red Hat, Inc ., Matthew J. Szulik and Kevin B. Thompson, Timothy J Buckley, Paul J. Cormier and Mark H. Webbink and served by U .S . Mail, postage prepaid, on May 6, 2005 to the following counsel :
Pressly M. Millen Jim W. Phillips, Jr. Christopher W. Jones BROOKS, PIERCE, MCLENDON, WOMBLE CARLYLE SANDRIDGE HUMPHREY & LEONARD, LLP & RICE 2000 Renaissance Plaza P.O. Box 831 Greensboro, NC 27420 Raleigh, NC 27602 Robert J. Kopecky Jeffrey B. Rudman Stacey G. Pagonis William H. Paine KIRKLAND & ELLIS LLP WILMER CUTLER PICKERING HALE AND 200 East Randolf Drive DORR LLP Chicago, IL 6060 1 60 State Street Boston, MA 02109 Counsel for Defendant PricewaterhouseCoopers
Counselfor Defendants Red Hat, Inc., Matthew J. Szulik and Kevin B. Thompson, Timothy J. Buckley, Paul J. Cormier and Mark H. Webbink 4t't Red Hat, Inc. Summary of Defendants' Sales
Red Hat Summa of Defendants Sales 1/00 - 7/04 Class Period: 1217/02 - , 7/12/04 Source: Form 4's Shares Name Date Sold Price Proceeds
M. SZULIK 2/9/2000 38,826 $90.73 $3,522,683 1/9/2002 100,000 $9.07 $907,000 Pre-Class Period Sales 1/17/2002 15,000 $8.25 $123,750 January 2000 -12/17/02 1/22/2002 15,000 $8.75 $131,250 Shares Proceeds 1/28/2002 15,000 $8.41 $126,150 213,826 $5,048,883 2/4/2002 15,000 $8.25 $123,750 2.76% of holdings sold 2/11/2002 15,000 $7.62 $114,300
Class Period Sales 1/7/2003 250,000 $6.05 $1,512,500 12/17/02 - 7/12/04 5/28/2003 5,000 $7.50 $37,500 Shares Proceeds 5/29/2003 2,500 $7.50 $18,750 2,899,800 $43,597,194 6/2/2003 20,000 $7.50 $150,000 30.32% of holdings sold 6/4/2003 12,500 $7.64 $95,500 6/6/2003 5,000 $8.95 $44,750 6/6/2003 5,000 $9.00 $45,000 6/13/2003 10,000 $8 .22 $82,200 6/17/2003 10,000 $8.05 $80,500 6/18/2003 10,100 $8.56 $86,456 6/24/2003 10,000 $7.50 $75,000 6/25/2003 15,000 $7.80 $117,000 7/1/2003 24,900 $7.64 $190,236 7/2/2003 50,000 $7.69 $384,500 7/2/2003 50,000 $7.68 $384,000 7/2/2003 50,000 $7.66 $383,000 7/2/2003 25,000 $7.68 $192,00 0 7/2/2003 25,000 $7.69 $192,25 0 7/2/2003 23,500 $7 .67 $180,24 5 7/2/2003 15,000 $7 .66 $114,900 7/2/2003 8,000 $7.66 $61,280 7/2/2003 2,100 $7.67 $16,107 7/2/2003 1,400 $7.67 $10,738 7/7/2003 5,000 $7.80 $39,000 7/7/2003 5,000 $7.78 $38,900 7/9/2003 5,000 $8.23 $41,150 7/9/2003 5,000 $8.25 $41,250 9/3/2003 20,000 $7.50 $150,000 9/3/2003 10,000 $7.55 $75,500 9/3/2003 5,500 $7.80 $42,900 9/3/2003 5,000 $7.60 $38,000 9/3/2003 5,000 $7.70 $38,500 9/3/2003 4,400 $7.82 $34,408 9/3/2003 100 $7.83 $783 9/8/2003 6,100 $8.47 $51,667 9/8/2003 5,000 $8.50 $42,500
Page 1 of 14 Red Hat, Inc. Summary of Defendants' Sale s
9/8/2003 5,000 $8.55 $42,750 9/8/2003 3,000 $8.45 $25,350 9/8/2003 600 $8.45 $5,070 9/8/2003 300 $8.45 $2,535 9/9/2003 10,000 $8.50 $85,000 9/10/2003 4,100 $8.10 $33,21 0 9/10/2003 900 $8.25 $7,425 9/11/2003 2,400 $8.47 $20,328 9/11/2003 1,000 $8.49 $8,490 9/11/2003 500 $8.46 $4,230 9/11/2003 400 $8.45 $3,380 9/11/2003 400 $8.46 $3,384 9/11/2003 100 $8.42 $842 9/11/2003 100 $8.44 $844 9/11/2003 100 $8.47 $847 9/12/2003 9,000 $8.20 $73,800 9/12/2003 500 $8.21 $4,105 9/12/2003 400 $8.20 $3,280 9/12/2003 100 $8.20 $820 9/15/2003 5,000 $8.60 $43,000 9/15/2003 4,800 $8.40 $40,320 9/15/2003 200 $8.41 $1,682 9/17/2003 8,800 $8.55 $75,240 9/17/2003 5,000 $8.60 $43,000 9/17/2003 1,200 $8.47 $10,164 9/18/2003 2,400 $8.60 $20,640 9/19/2003 5,000 $9.90 $49,500 9/19/2003 5,000 $9.80 $49,000 9/19/2003 5,000 $9.75 $48,750 9/19/2003 4,200 $9.62 $40,404 9/19/2003 2,500 $9.63 $24,075 9/19/2003 700 $9.62 $6,734 9/19/2003 100 $9.78 $978 9/19/2003 100 $9.73 $973 9/22/2003 5,000 $10.40 $52,000 9/22/2003 3,000 $10.15 $30,450 9/22/2003 2,500 $10.50 $26,250 9/22/2003 2,500 $10.45 $26,125 9/22/2003 2,000 $10.16 $20,320 9/23/2003 2,500 $10.50 $26,250 9/23/2003 2,500 $10.60 $26,500 9/25/2003 5,000 $9.66 $48,300 9/25/2003 4,100 $9.89 $40,549 9/25/2003 3,100 $9.88 $30,628 9/25/2003 1,500 $9.86 $14,790 9/25/2003 700 $9.86 $6,902 9/25/2003 400 $9.87 $3,948 9/25/2003 200 $9.85 $1,970 9/26/2003 5,500 $9.39 $51,645 i 9/26/2003 4,700 $9.75 $45,825 9/26/2003 2,600 $9.45 $24,570 9/26/2003 1,400 $9.40 $13,160
Page 2 of 14 Red Hat , Inc. Summary of Defendants' Sales
9/26/2003 300 $9.76 $2,928 9/26/2003 200 $9.44 $1,888 9/26/2003 200 $9.41 $1,882 9/26/2003 100 $9.42 $942 9/30/2003 5,000 $10.25 $51,250 9/30/2003 4,050 $10.06 $40,743 9/30/2003, 4,000 $9.87 $39,480 9/30/2003 2,700 $9.67 $26,109 9/30/2003 1,300 $9.63 $12,51 9 9/30/2003 950 $10.05 $9,548 9/30/2003 800 $9.65 $7,720 9/30/2003 400 $9.91 $3,964 9/30/2003 400 $9.89 $3,956 9/30/2003 200 $9.66 $1,932 9/30/2003 100 $9.90 $990 9/30/2003 100 $9.87 $987 10/3/2003 3,900 $10.87 $42,393 10/3/2003 1,100 $10.86 $11,946 10/7/2003 5,000 $11 .05 $55,250 10/7/2003 2,800 $10.96 $30,688 1017/2003 1,700 $10.92 $18,564 10/7/2003 200 $10.95 $2,190 10/7/2003 200 $10 .94 $2,188 10/7/2003 100 $10.97 $1,097 10/9/2003 3,800 $11 .16 $42,408 10/9/2003 1,200 $11 .15 $13,380 10/13/2003 5,000 $11 .61 $58,050 10/13/2003 5,000 $12.09 $60,450 10/13/2003 5,000 $12.40 $62,000 10/13/2003 5,000 $12.65 $63,250 10120/2003 5,000 $13.20 $66,000 10/21/2003 5,000 $13.40 $67,000 10/24/2003 9,700 $13.10 $127,070 10/24/2003 300 $13.20 $3,960 10/27/2003 3,000 $13.65 $40,950 10/27/2003 2,000 $13.66 $27,320 10/28/2003 5,000 $13.80 $69,000 10/29/2003 4,000 $14.00 $56,000 10/29/2003 5,000 $14.30 $71,500 10/29/2003 1,000 $14.01 $14,01 0 11/3/2003 5,000 $15.10 $75,500 11/3/2003 2,500 $15.35 $38,375 11/3/2003 1,100 $15.31 $16,841 11/3/2003 1,000 $15.35 $15,350 11/3/2003 300 $15.32 $4,596 11/3/2003 100 $15.30 $1,530 11/6/2003 4,100 $13.63 $55,883 11/6/2003 800 $13.62 $10,896 11/6/2003 100 $13.65 $1,365 1117/2003 5,000 $13.62 $68,100 11/10/2003 5,000 $13.50 $67,500 11/12/2003 5,000 $13.50 $67,500
Page 3 of 14 Red Hat, Inc. Summary of Defendants' Sale s
11/13/2003 4,800 $13.61 $65,328 11/13/2003 100 $13.66 $1,366 11/13/2003 100 $13.60 $1,360 11/20/2003 5,000 $12.00 $60,000 11/20/2003 5,000 , $12.25 $61,250 11/20/2003 5,000 $12.50 $62,500 1/12/2004 45,000 $21 .02 $945,900 1/12/2004 30,000 $21 .00 $630,000 1/12/2004 30,000 $21 .03 $630,900 1/12/2004 12,000 $21 .01 $252,120 1/13/2004 12,000 $20.90 $250,800 1/16/2004 61,000 $20.51 $1,251,11 0 1/16/2004 50,000 $20.25 $1,012,500 1/16/2004 50,000 $20.35 $1,017,500 1/16/2004 50,000 $20 .46 $1,023,000 1/16/2004 10,000 $20.62 $206,200 1/30/2004 39,500 $19.41 $766,695 1/30/2004 10,500 $19.50 $204,750 2/2/2004 19,900 $18.50 $368,150 2/2/2004 19,900 $18.75 $373,125 2/2/2004 9,800 $18.65 $182,770 2/2/2004 200 $18.66 $3,732 2/2/2004 200 $18.77 $3,754 2/4/2004 10,000 $17.80 $178,000 2/4/2004 5,100 $17.63 $89,913 2/4/2004 4,900 $17.60 $86,240 2/5/2004 30,000 $17.60 $528,000 2/5/2004 20,000 $17.70 $354,000 2/5/2004 20,000 $17.80 $356,000 2/5/2004 12,800 $17.95 $229,760 2/5/2004 10,000 $17.90 $179,000 2/5/2004 5,200 $17.96 $93,392 2/5/2004 4,400 $17.76 $78,144 2/5/2004 3,800 $17.75 $67,450 2/5/2004 1,800 $17.77 $31,986 215/2004 1,200 $17.97 $21,564 2/5/2004 400 $17.95 $7,180 2/5/2004 400 $17.96 $7,184 2/6/2004 63,800 $18.05 $1,151,590 2/6/2004 60,500 $18.10 $1,095,050 2/6/2004 41,300 $18.20 $751,660 2/6/2004 25,000 $18.00 $450,000 2/6/2004 5,900 $18.17 $107,203 2/6/2004 4,700 $18.08 $84,976 2/6/2004 3,300 $18.11 $59,763 2/6/2004 2,300 $18.19 $41,837 2/6/2004 2,200 $18.30 $40,260 2/6/2004 1,600 $18.26 $29,21 6 2/6/2004 1,400 $18.27 $25,578 2/6/2004 800 $18.26 $14,608 2/6/2004 700 $18.07 $12,649 2/6/2004 700 $18.29 $12,803
Page 4 of 14 Red Hat, Inc. Summary of Defendants' Sales
216/2004 600 . $18.12 $10,872 2/6/2004 600 $18.29 $10,974 2/6/2004 600 $18.30 $10,980 2/6/2004 500 $18.25 $9,125 2/6/2004 500 $18.28 $9,140 2/6/2004 400 $18.51 $7,404 2/6/2004 400 $18.52 $7,408 2/6/2004 400 $18.11 $7,244 2/6/2004 400 $18.18 $7,272 2/6/2004 400 $18.30 $7,320 2/6/2004 300 $18.27 $5,481 2/6/2004 200 $18.15 $3,630 2/6/2004 200 $18.26 $3,652 2/6/2004 200 $18.28 $3,656 2/6/2004 100 $18.14 $1,81 4 2/9/2004 37,100 $18.50 $686,350 2/9/2004 400 $18 .51 $7,404 2/10/2004 32,400 $18 .00 $583,200 2/10/2004 1,000 $18.03 $18,030 2/10/2004 400 $18.02 $7,208 2/10/2004 300 $18.01 $5,403 2/10/2004 300 $18.02 $5,406 2/10/2004 100 $18.00 $1,800 2/10/2004 100 $18.05 $1,805 2/11/2004 35,000 $18.20 $637,000 2/11/2004 25,000 $18.35 $458,750 2/11/2004 24,600 $18.15 $446,490 2/11/2004 21,900 $18.00 $394,200 2/11/2004 21,000 $18.10 $380,10 0 2/11/2004 15,000 $18.05 $270,750 2/11/2004 15,000 $18.11 $271,65 0 2/11/2004 13,500 $18.16 $245,16 0 2/11/2004 10,000 $18.06 $180,600 2/11/2004 10,000 $18.08 $180,800 2/11/2004 10,000 $18.12 $181,200 2/11/2004 10,000 $18.13 $181,300 2/11/2004 7,500 $18.01 $135,075 2/11/2004 6,500 $18.25 $118,625 2/12/2004 8,775 $18.77 $164,707 2/12/2004 6,700 $18.89 $126,563 2/12/2004 1,525 $18.80 $28,670 2/12/2004 1,200 $18.86 $22,632 2/12/2004 700 $18.81 $13,167 2/12/2004 400 $18.87 $7,548 2/12/2004 400 $18.88 $7,552 2/12/2004 300 $18.84 $5,652 2/13/2004 4,000 $18.62 $74,480 2/13/2004 2,800 $18.65 $52,220 2/13/2004 2,600 $18.54 $48,204 2/13/2004 2,400 $18.45 $44,280 2/13/2004 1,600 $18.63 $29,808 2/13/2004 1,300 $18.60 $24,180
Page 5 of 14 Red Hat, Inc. Summary of Defendants' Sales
2/13/2004 1,200 $18.50 $22,200 2/13/2004 1,100 $18.64 $20,504 2/13/2004 900 $18.63 $16,767 2/13/2004 500 $18.49 $9,245 2/13/2004 400 $18.65 $7,460 2/13/2004 400 $18.65 $7,460 2/13/2004 300 $18.44 $5,532 2/13/2004 200 $18.51 $3,702 2/13/2004 200 $18.60 $3,720 2/13/2004 100 $18.53 $1,853 2/17/2004 20,000 $18.55 $371,000 2/17/2004 19,000 $18.50 $351,50 0 2/17/2004 7,900 $18.60 $146,940 2/17/2004 600 $18.51 $11,106 2/17/2004 400 $18.50 $7,400 2/18/2004 4,500 $18.25 $82,125 2/19/2004 7,200 $18.30 $131,760 2/19/2004 3,500 $18.35 $64,225 2/19/2004 2,300 $18.41 $42,343 2/19/2004 600 $18.35 $11,010 2/19/2004 600 $18.38 $11,028 2/19/2004 400 $18.39 $7,356 2119/2004 300 $18.38 $5,514 2/19/2004 300 $18.34 $5,502 2/19/2004 200 $18.30 $3,660 2/19/2004 200 $18.39 $3,678 2/19/2004 200 $18.32 $3,664 2/19/2004 200 $18.33 $3,666 2/19/2004 100 $18.31 $1,831 2/20/2004 36,500 $17.60 $642,400 2/20/2004 31,400 $17.50 $549,500 2/20/2004 8,100 $17.61 $142,64 1 2/20/2004 7,200 $17.51 $126,072 2120/2004 3,200 $17.52 $56,064 2/20/2004 2,800 $17.56 $49,168 2/20/2004 2.400 $17.63 $42,31 2 2/20/2004 2,200 $17.53 $38,566 2/20/2004 1,400 $17.55 $24,570 2/20/2004 1,000 $17.63 $17,630 2/20/2004 900 $17.54 $15,786 2/20/2004 600 $17.65 $10,590 2/20/2004 400 $17.52 $7,008 2/20/2004 400 $17.61 $7,044 2/20/2004 400 $17.61 $7,044 2/20/2004 300 $17.62 $5,286 2/20/2004, 300 $17.64 $5,292 2/20/2004 200 $17.51 $3,502 2/20/2004 200 $17.51 $3,502 2/20/2004 100 $17.50 $1,750 2/24/2004 25,000 $17.00 $425,000 2/25/2004 25,000 $17.30 $432,500 2/25/2004 25,000 $17.35 $433,750
Page 6 of 14 Red Hat , Inc. Summary of Defendants' Sales
2/25/2004 15,000 $17.01 $255,150 2/25/2004 15,000 $17.21 $258,150 2/25/2004 10,000 $17.00 $170,000 2/25/2004 10,000 $17.20 $172,00 0 2/26/2004 25,000 $17.30 $432,50 0 2/26/2004 25,000 $17.65 $441,250 2126/2004 25,000 $17.70 $442,500 2/26/2004 10,300 $17.55 $180,765 2/26/2004 3,400 $17.45 $59,330 2/26/2004 2,500 $17.53 $43,825 2/26/2004 2,000 $17.51 $35,020 2/26/2004 1,600 $17.50 $28,000 2/26/2004 1,200 $17.85 $21,420 2/26/2004 1,100 $17.52 $19,272 2/26/2004 1,000 $17.50 $17,500 2/26/2004 700 $17.46 $12,222 2/26/2004 700 $17.56 $12,292 2/26/2004 500 $17.47 $8,735 2/26/2004 400 $17.46 $6,984 -- - - 2/26/2004 400 $17.51 $7,004 2/26/2004 200 $17.47 $3,494 2/26/2004 100 $17.49 $1,749 2/26/2004 100 $17.60 $1,760 2/27/2004 50,000 $18.00 $900,000 2/27/2004 25,000 $17.80 $445,00 0 2/27/2004 23,300 $18.12 $422,19 6 2/27/2004 1,700 $18.10 $30,770 3/1/2004 25,000 $18.40 $460,000 3/1/2004 20,000 $18.60 $372,000 3/1/2004 15,000 $18.50 $277,500 3/1/2004 10,000 $18.55 $185,500 3/1/2004 10,000 $18.65 $186,500 3/2/2004 15,000 $18.60 $279,000 3/4/2004 14,700 $19.00 $279,300 3/4/2004 10,200 $18.60 $189,72 0 3/4/2004 10,100 $18.75 $189,37 5 3/4/2004 10,000 $18.85 $188,50 0 3/4/2004 9,900 $18.70 $185,130 3/4/2004 ; 9,900 $18.95 $187,605 3/4/2004 9,800 $18.50 $181,300 3/4/2004 4,300 $19.0.1 $81,743 3/4/2004 700 $19.02 $13,314 3/4/2004 400 $19.03 $7,612 3/5/2004 27,100 $19.00 $514,900 3/5/2004 18,000 $19.13 $344,340 3/5/2004 10,000 $19.25 $192,500 3/5/2004 10,000 $19.53 $195,300 3/5/2004 9,900 $19.40 $192,060 3/5/2004 4,900 $19.11 $93,639 3/5/2004 4,700 $19.10 $89,770 3/5/2004 4,500 $19.15 $86,175 3/5/2004 1,600 $19.18 $30,688
Page 7 of 14 Red Hat, Inc. Summary of Defendants' Sales
3/5/2004 1,100 $19.17 $21,087 3/5/2004 900 $19.16 $17,244 3/5/2004 200 $19.17 $3,834 3/5/2004 100 $19.45 $1,945
M. SZULIK Pre - Class: 213,826 $5,048,883 Class Period : 2,899,800 $43,597,194
K. THOMPSON
Pre-Class Period Sales 1/9/2004 30,000 $19.59 $587,700 January 2000 -12117/02 1/9/2004 30,000 $19.58 $587,400 Shares Proceeds 1/9/2004 10,000 $19.55 $195,500 0 $0 1/22/2004 5,000 $20.25 $101,250 0.00% of holdings sold 4/7/2004 50,000 $23.98 $1,199,000 4/7/2004 10,000 $23.96 $239,600 Class Period Sale s 12117/02 - 7112/04 Pro - Class: 0 $0 Shares Proceeds Class Period : 135,000 $2,910,450 135,000 $2,910,450 23.35% of holdings sol d
T. BUCKLEY 6/21/2000 100,000 $29.80 $2,980,000 9/20/2000 20,000 $20.00 $400,000 Pre-Class Period Sales 9/22/2000 20,000 $19.07 $381,400 January 2000 -12/17102 9/25/2000 40,000 $19.69 $787,600 Shares Proceeds 9/26/2000 30,000 $18.75 $562,500 985,000 $10,111,665 9/27/2000 30,000 $18.76 $562,800 23.70% of holdings sold 10/3/2000 30,000 $16.12 $483,600 7/11/2001 2,000 $3.92 $7,840 7/12/2001 2,000 $3.90 $7,800 7/13/2001 2,000 $3.92 $7,840 7/16/2001 2,000 $3.90 $7,800 7/17/2001 300 $3.70 $1,110 7/18/2001 3,700 $3.75 $13,875 7/19/2001 2,000 $3.63 $7,260 7/20/2001 2,000 $3.38 $6,760 7/23/2001 2,000 $3.55 $7,100 7/24/2001 2,000 $3.69 $7,380 7/25/2001 2,000 $4.09 $8,180 7/26/2001 2,000 $4.00 $8,000 7/27/2001 2,000 $4.02 $8,040 7/30/2001 2,000 $3.98 $7,960 7/31/2001 2,000 $3.94 $7,880 8/1/2001 2,000 $3.96 $7,920 8/2/2001 2,000 $3.96 $7,920 8/3/2001 2,000 $4.00 $8,000
Page 8 of 14 Red Hat, Inc. Summary of Defendants' Sale s
8/6/2001 2,000 $3.96 $7,920 8/7/2001 2,000 $3.95 $7,900 8/8/2001 2,000 $3.90 $7,800 8/9/2001 2,000 $3.80 $7,600 8/10/2001 2,000 $3.80 $7,600 8/13/2001 2,000 $3.71 $7,420 8/14/2001 2,000 $3.72 $7,440 8/15/2001 2,000 $3.71 $7,420 8/16/2001 2,000 $3.79 $7,580 8/17/2001 2,000 $3.86 $7,720 8/20/2001 2,000 $3.85 $7,700 8/21/2001 2,000 $3.86 $7,720 8/22/2001 2,000 $3.75 $7,500 8/23/2001 2,000 $3.69 $7,380 8/24/2001 2,000 $3.65 $7,300 8/27/2001 2,000 $3.66 $7,320 8/28/2001 2,000 $3.52 $7,040 8/29/2001 2,000 $3.40 $6,800 8/30/2001 2,000 $3.45 $6,900 8/31/2001 2,000 $3.41 $6,820 9/4/2001 2,000 $3.50 $7,000 9/5/2001 2,000 $3.46 $6,920 9/6/2001 2,000 $3.25 $6,500 9f7/20011 2,000 $3.01 $6,020 9/10/2001 2,000 $3.15 $6,300 9/17/2001 10,000 $2.76 $27,600 12/21/2001 100,000 $6.72 $672,000 12/24/2001 3,000 $6.92 $20,760 12/26/2001 3,000 $7.07 $21,21 0 12/27/2001 3,000 $7.00 $21,000 12/28/2001 3,000 $6.74 $20,220 12/31/2001 3,000 $7.00 $21,000 1/2/2002 3,000 $6.90 $20,700 1/3/2002 3,000 $7.16 $21,480 1/4/2002 3,000 $7.57 $22,71 0 1/7/2002 3,000 $8.11 $24,330 1/8/2002 3,000 $8.75 $26,250 1/9/2002 3,000 $8.90 $26,700 1/10/2002 3,000 $8.62 $25,860 1/1 1/2002 3,000 $8.60 $25,800 1/14/20021 3,000 $8.59 $25,770 1/15/2002 3,000 $8.67 $26,01 0 1/16/2002 3,000 $8.38 $25,140 1/17/2002 3,000 $8.07 $24,210 1 1/18/2002, 3,000 $8.90 $26,700 1/22/2002 3,000 $8.86 $26,580 1/23/2002 1 3,000 $7.90 $23,700 1124/2002 , 3,000 $8.14 $24,420 1/25/2002 3,000 $7.84 $23,520 1/28/2002 3,000 $8.38 $25,140 1/29/2002 3,000 $8.45 $25,350 1/30/2002 3,000 $8.03 $24,090
Page 9 of 14 Red Hat, Inc. Summary of Defendants' Sales
1/31/2002 3,000 11 $8.00 $24,000 2/1/2002 3,000 $8.59 $25,770 2/4/2002 3,000 $8.17 $24,51 0 2/5/2002 3,000 $8.05 $24,150 2/6/2002 3,000 $7.70 $23,100 2/7/2002 3,000 $7.00 $21,000 2/8/2002 3,000 $7.22 $21,660 2/11/2002 3,000 $7.50 $22,500 2/12/2002 3,000 $7.33 $21,990 2/13/2002 3,000 $7.43 $22,290 2/14/2002 3,000 $7.28 $21,840 2/15/2002 3,000 $8.38 $25,140 2/19/2002 3,000 $7.10 $21,300 2/20/2002 3,000 $6.71 $20,130 2/21/2002 3,000 $5.95 $17,850 2/22/2002 3,000 $5.94 $17,820 2/25/2002 3,000 $6.10 $18,300 2/26/2002 3,000 $6.15 $18,450 2/27/2002 3,000 $6.30 $18,900 2/28/2002 3,000 $5.83 $17,490 4/1/2002 3,000 $5.60 $16,800 4/2/2002 3,000 $5.50 $16,500 4/3/2002 3,000 $5.11 $15,330 4/4/2002 3,000 $5.01 $15,030 4/5/2002 3,000 $5.03 $15,090 4/8/2002 3,000 $4.73 $14,190 4/9/2002 3,000 $5.21 $15,630 4/10/2002 3,000 $5.15 $15,45 0 4/11/2002 3,000 $4.96 $14,880 4/12/2002 3,000 $5.02 $15,060 4/15/2002 3,000 $5.00 $15,000 4/16/2002 3,000 $5.31 $15,930 4/17/2002 3,000 $5.21 $15,630 4/18/2002 3,000 $5.31 $15,930 4/19/2002 3,000 $5.20 $15,600 4/22/2002 3,000 $4.85 $14,550 4/23/2002 3,000 $4.48 $13,440 4/24/2002 3,000 $4.58 $13,740 4/25/2002 3,000 $4.64 $13,920 4/26/2002 3,000 $4.55 $13,650 4/29/2002 3,000 $4.55 $13,650 4/30/2002 3,000 $4.37 $13,11 0 5/1/2002 3,000 $4.35 $13,050 5/2/2002 3,000 $4.65 $13,950 5/3/2002 3,000 $4.85 $14,550 5/6/2002 3,000 $4.86 $14,580 5/7/2002 3,000 $4.45 $13,350 5/8/2002 3,000 $4.62 $13,860 5/9/2002 3,000 $4 .86 $14,580 5/10/2002 3,000 $4 .84 $14,520 5/13/2002 3,000 $5.19 $15,570 5/14/2002 3,000 $5.41 $16,230
Page 10 of 14 Red Hat, Inc. Summary of Defendants' Sales
5115/2002 3,000 $5.05 $15,150 5/16/2002 3,000 $5.03 $15,090 5/17/2002 3,000 $5.06 $15,180 5/20/2002 3,000 $4.80 $14,400 5/21/2002 3,000 $4.77 $14,31 0 5/22/2002 3,000 $4.86 $14,580 5/23/2002 3,000 $4.63 $13,890 5/24/2002 3,000 $4.51 $13,530 5/28/2002 3,000 $4.40 $13,200 5/29/2002 3,000 $4.33 $12,990 5/30/2002 3,000 $4.25 $12,750 5/31/2002 3,000 $4.63 $13,890 6/3/2002 3,000 $4.66 $13,980 6/4/2002 3,000 $4.67 $14,01 0 6/5/2002 3,000 $4.95 $14,850 6/6/2002 3,000 $4.75 $14,250 6/7/2002 3,000 $4.59 $13,770 6/10/2002 3,000 $4.98 $14,940 6/11/2002 3,000 $5.28 $15,840 6/12/2002 3,000 $5.02 $15,060 6/13/2002 3,000 $5.08 $15,240 6/14/2002 3,000 $4.95 $14,850 6/17/2002 3,000 $5.50 $16,500 6/18/2002 3,000 $5.56 $16,680 6/19/2002 3,000 $5.36 $16,080 6/20/2002 3,000 $5.35 $16,050 6/21/2002 3,000 $5.32 $15,960 6/24/2002 3,000 $5.19 $15,570 6/25/2002 3,000 $5.47 $16,410 6/26/2002 3,000 $5.35 $16,050 6/27/2002 3,000 $5.48 $16,440 6/28/2002 3,000 $5.69 $17,070 7/1/2002 3,000 $5.54 $16,620 7/2/2002 3,000 $5.29 $15,870 7/3/2002 3,000 $5.14 $15,420 7/5/2002 3,000 $5.37 $16,11 0 7/8/2002 3,000 $5.30 $15,900 7/9/2002 3,000 $5.11 $15,330 7/10/2002 3,000 $5.25 $15,750 7/11/2002 3,000 $5.30 $15,900 7/12/2002 3,000 $5.65 $16,950 7/15/2002 3,000 $5.64 $16,920 7/16/2002 3,000 $5.57 $16,71 0 7/17/2002 3,000 $5.54 $16,620 7/18/2002 3,000 $5.46 $16,380 7/19/2002 3,000 $5.51 $16,530 7/22/2002 3,000 $5.37 $16,11 0 7/23/2002 3,000 $5.36 $16,080 7/24/2002 3,000 $5.34 $16,020 7/25/2002 3,000 $5.27 $15,81 0 7/26/2002 3,000 $4.57 $13,71 0 7/29/2002 3,000 $4.51 $13,530
Page 11 of 14 Red Hat, Inc. Summary of Defendants' Sale s
7/30/2002 3,000 $4.87 $14,61 0 7/31/2002 3,000 $4.85 $14,550 8/1/2002 3,000 $4.62 $13,860 8/2/2002 3,000 $4.37 $13,11 0 8/5/2002 3,000 $4.29 $12,870 8/6/2002 3,000 $4.34 $13,020 817/2002 3,000 $4.60 $13,800 8/8/2002 3,000 $4.82 $14,460 8/9/2002 3,000 $4.85 $14,550 8/12/2002 3,000 $5.23 $15,690 8/13/2002 3,000 $4.80 $14,400 8/14/2002 3,000 $4.67 $14,010 8/15/2002 3,000 $4.94 $14,820 8/16/2002 3,000 $4.77 $14,310 8/1912002 3,000 $5.01 $15,030 8/20/2002 3,000 $5.10 $15,300 8/21/2002 3,000 $5.21 $15,630 8/22/2002 3,000 $5.20 $15,600 8/23/2002 3,000 $5.20 $15,600 8/26/2002 3,000 $5.11 $15,330 8/27/2002 3,000 $5.00 $15,000 8/28/2002 3,000 $4.90 $14,700 8/29/2002 3,000 $4.67 $14,01 0 8/30/2002 3,000 $4.66 $13,980 9/3/2002 3,000 $4.56 $13,680 9/12/2002 3,000 $5.08 $15,240 9/13/2002 3,000 $5.20 $15,600 9/16/2002 3,000 $6.04 $18,120 9/17/2002 3,000 $5.76 $17,280 9/18/2002 3,000 $5.17 $15,510 9/19/2002 3,000 $5.05 $15,150 9/20/2002 3,000 $5.12 $15,360 9/23/2002 3,000 $4.81 $14,430 9/24/2002 3,000 $5.00 $15,000 9/25/2002 3,000 $4.98 $14,940 9/26/2002 3,000 $4.82 $14,460 9/27/2002 3,000 $4.85 $14,550 9/30/2002 3,000 $4.83 $14,490 10/1/2002 3,000 $4.71 $14,130 10/2/2002 3,000 $4.51 $13,530 10/3/2002 3,000 $4.41 $13,230 10/4/2002 3,000 $4.34 $13,020 10/8/2002 3,000 $3.61 $10,830 10/8/2002 3,000 $3.69 $11,070
Class Period Sales 1/7/2003 250,000 $6.05 $1,512,500 12117/02 - 7112104 9/23/2003 60,000 $10.40 $624,000 Shares Proceeds 9123/2003 30,000 $10.39 $311,700 2,667,240 $42,074,927 9/23/2003 30,000 $10.36 $310,800 100.00% of holdings sold 9/23/2003 30,000 $10.32 $309,600 9/23/2003 30,000 , $10.30 $309,000 9/23/2003 30,000 $10.19 $305,700
Page 12 of 14 Red Hat , Inc. Summary of Defendants' Sale s
9/23/2003 30,000 $10.27 $308,10 0 9/23/2003 30,000 $10.31 $309,30 0 9/23/2003 30,000 $10.21 $306,300 9/23/2003 20,624 $10.30 $212,42 7 9/23/2003 20,000 $10.30 $206,000 9/23/2003 9,376 $10.30 $96,573 10/20/2003 30,000 $13.11 $393,300 10/20/2003 30,000 $13.61 $408,300 10/20/2003 30,000 $13.15 $394,500 10/20/2003 23,500 $13.21 $310,435 10120/2003 23,481 $13.06 $306,662 10/2012003 21,300 $13.14 $279,882 10/20/2003 19,000 $13.04 $247,760 10/20/2003 8,700 $13.14 $114,31 8 10/20/2003 6,500 $13.06 $84,890 10/2012003 6,119 $13.01 $79,608 10/20/2003 1,000 $13.15 $13,150 10/20/2003 400 $13.14 $5,256 12/23/2003 1,416,163 $18.40 $26,057,39 9 12/23/2003 48,000 $18.55 $890,400 12/23/2003 30,000 $18.20 $546,00 0 12/23/2003 30,000 $18.20 $546,000 12/23/2003 30,000 $18.20 $546,000 12/23/2003 30,000 $18.21 $546,300 1 12/23/2003 30,000 $18.20 $546,00 0 12/23/2003 30,000 $18.21 $546,300 12/23/2003 30,000 $18.20 $546,00 0 12/23/2003 30,000 $18.20 $546,000 12/23/2003 30,000 $18.21 $546,30 0 12/23/2003 30,000 $18.22 $546,600 12/23/2003 29,000 $18.45 $535,05 0 12/23/2003 29,000 $18.46 $535,34 0 12/23/2003 18,150 $18.58 $337,22 7 12/23/2003 12,237 $18.56 $227,11 9 12/23/2003 7,240 $18.26 $132,202 12/23/2003 6,450 $18.62 $120,099 12/23/2003 1,000 $18.53 $18,530
T. BUCKLEY Pro - Class: 985,000 $10,111,665 Class Period : 2,667,240 $42,074,927
P. CORMIER 1/9/2004 20,000 $20.28 $405,600 1/9/2004 20,000 $20.30 $406,000 Pre-Class Period Sales 4/712004 39,000 $24 .00 $936,000 January 2000 - 12117102 4/7/2004 1,000 $24 .12 $24,120 Shares Proceeds 0 $0 Pro - Class: 0 $0 0.00% of holdings sold Class Period: 80,000 $1,771,720
Page 13 of 14 Red Hat, Inc. Summary of Defendants' Sales
Class Period Sales 12/17/02 - 7112/04 Shares Proceeds 80,000 $1,771,720 21 .75% of holdings sold
M. WEBBINK 10/28/2002 908 $4.65 $4,222
Pre-Class Pe riod Sales 1/10/2003 4,000 $6.35 $25,400 January 2000 -12117/02 1/13/2003 6,000 $6.41 $38,460 Shares Proceeds 7/2/2003 50,000 $7.68 $384,000 908 $4,222 7/2/2003 15,000 $7.77 $116,550 1 .95% of holdings sold 7/2/2003 15,000 $7.75 $116,250 1/9/2004 4,000 $20.52 $82,080 Class Period Sales 1 /12/2004 4,000 $20.65 $82,600 12/17/02 - 7/12/04 1/28/2004 4,000 $20.61 $82,440 Shares Proceeds 3/24/2004 4,000 $21 .84 $87,360 215,706 $3,701,360 3/24/2004 4,000 $21 .88 $87,520 76.00% of holdings sold 3/29/2004 4,000 $22.48 $89,920 3/29/2004 4,000 $22.47 $89,880 3/29/2004 4,000 $23.50 $94,000 4/5/2004 8,000 $23.72 $189,760 4/5/2004 4,000 $23.73 $94,920 4/12/2004 10,500 $24.75 $259,875 4/12/2004 8,000 $24.20 $193,600 4/12/2004 4,000 $25.00 $100,000 4/12/2004 1,591 $24.66 $39,234 4/19/2004 2,490 $23.19 $57,743 4/26/2004 3,125 $24.22 $75,688 4/27/2004 8,000 $26.00 $208,000 4/27/2004 4,000 $25.98 $103,920 5/3/2004 4,000 $23.50 $94,000 5/4/2004 4,000 $25.00 $100,000 5/10/2004 4,000 $24.12 $96,480 5/11/2004 4,000 $25.00 $100,000 5/17/2004 8,000 $25.00 $200,000 5/24/2004 16,000 $25.73 $411,680
Pre - Class: 908 $4,222 Class Period : 215,7061 $3,701,360
Page 14 of 14