Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-cand-3_05-cv-00392/USCOURTS-cand-3_05-cv-00392-14/pdf.json

Nature of Suit Code: 850
Nature of Suit: Securities, Commodities, Exchange
Cause of Action: 15:78m(a) Securities Exchange Act

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United States District Court

For the Northern District of California

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IN THE UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF CALIFORNIA

IN RE SIPEX CORPORATION 

SECURITIES LITIGATION

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AND CONSOLIDATED CASES

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No. C 05-00392 WHA

ORDER DENYING MOTIONS

TO DISMISS (EXCEPT AS TO

PHILIP KAGEL)

Sipex’s own public admission that its financial reports for the period in question should

not be relied upon and would be “restated” meant that the as-issued reports were materially

inaccurate under GAAP. The company’s Form 8K (filed April 19, 2005) conceded that it had

improperly recognized revenue for sales in which price protection, stock rotation, and/or return

rights and other concessions were granted during the period in question. A year has passed and

still no restatement has emerged. These circumstances, however, do not alone raise a strong

inference of scienter. Financial reporting errors, even material ones, can result from innocent

mistakes or mere negligence. 

Sipex, however, has further admitted that its audit committee conducted an internal

investigation and recommended certain remedial actions later approved by the board of

directors, including:

• Termination of certain employees,

• Restructuring the customer-marketing function to require that all its

finance-related activities be performed by the finance department,

Case 3:05-cv-00392-WHA Document 117 Filed 11/17/05 Page 1 of 5
United States District Court

For the Northern District of California

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• Annual ethics training for all employees,

• Annual compliance confirmation for all employees,

• Certification from the appropriate sales and marketing personnel, and

• Staff increases to upgrade the finance function.

This was strong medicine. Such house-cleaning and reforms do not follow innocent

mistakes. Rather, they customarily, even if not invariably, follow systemic and fraudulent abuse

of internal financial controls. These circumstances, combined with the announcement of the

impending restatement establish a strong inference that the company itself believes that fraud led

to materially misleading financials for the period in question. This seems even clearer in light of

the probability that CEO Walid Maghribi’s resignation was forced, coming as it did only days

before the commencement of the internal legal and accounting investigation.

The complaint establishes (for purposes of this motion) that CEO Maghribi, during the

period in question, personally orchestrated a sham “sale” in the amount of $350,000. This is not a

vague allegation. It is described in painful detail in the complaint (¶¶ 49–53). Sham transactions

like the one alleged have no place in honest commerce. No CEO in a public company should

engineer such phony deals even if they are themselves not material. 

Defendants suggest that the sham transaction never hit the books and was never reflected

in the published financials. This argument fails at the pleading stage. Many decades of

experience teach that sham transactions like the one alleged are not done for the fun of it — they

are done to cook the books. At all events, contrary to the defense, the complaint does allege that

the transaction was recorded and affected the books (¶¶ 51–53). Finally, that Sipex itself has

announced that its financials for the period in question were overstated revenue lends distinct

credibility to the charge.

Defendants say that $350,000 has not been shown to be “material.” For a company of

Sipex’s size, with reported quarterly revenues of about $17 million, defendants may ultimately be

right. A $350,000 revenue item, however, cannot be said to be immaterial as a matter of law at

the pleading stage. SEC Staff Accounting Bulletin No. 99 — Materiality, 17 C.F.R. Part 211

(Aug. 12, 1999); Ganino v. Citizens Utilities Co., 228 F.3d 154, 162–63 (2d Cir. 2000). 

Case 3:05-cv-00392-WHA Document 117 Filed 11/17/05 Page 2 of 5
United States District Court

For the Northern District of California

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Moreover, the sham transaction was material in a wholly different sense: Investors would be

interested in knowing that the company CEO, president and director was personally orchestrating

the phony sale alleged. This would have raised a red flag for investors that top management was

potentially corrupt. This was not disclosed. This alone made the sham transaction material. 

As noted, the company has publicly admitted that its financials for the period in question

improperly recognized revenue on sales “for which price protection, stock rotation and/or return

rights and other concessions were granted” (Form 8-K filed Apr. 19, 2005). The complaint

parrots these admissions. It alleges that the company represented that no distributor received any

“price protection” (¶¶ 84, 89, 130). The Form 8-K now reveals, however, that this was untrue, as

the complaint also alleges (see, e.g., ¶ 133). While we cannot glean from the complaint the extent

of price protection, Sipex itself has admitted in its Form 8K filings that price protection practices

contributed to the overstatement. Combined with the rest of the complaint, this is enough to

sustain the allegation that undisclosed price protection contributed to a material overstatement.

As to returned merchandise, CW5 was a former senior manager immediately prior to the

class period and was heavily involved in the accounting function. CW5 alleges that CEO

Maghribi entered into “side agreements” with “some of the distributors” for returning product at

will. Sipex recognized revenue on sales to such distributors but allegedly should not have

because of the right of return. On the other hand, Sipex’s public statements acknowledged at the

time that “limited return rights” existed. CW5 did not explain the extent of any return rights. 

Return rights are not per se improper. Revenue recognition depends in part on whether the extent

of future returns can be reasonably estimated. The complaint does not illuminate this factor. 

CW5 goes on to say that detailed reports on the returns were provided to the company’s auditors

on a quarterly basis (¶ 66). That the outside auditors were reviewing the return number

(presumably for GAAP compliance) tends to validate the reported figures rather than undermine

them. These factors favor the defense. On the other hand, the Form 8-K confirms that “stock

rotation for return rights and other concessions” were, in fact, granted. Given this further

admission, the Court will sustain this allegation despite its lack of supporting detail. 

Case 3:05-cv-00392-WHA Document 117 Filed 11/17/05 Page 3 of 5
United States District Court

For the Northern District of California

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As to the alleged practice of “pulling in sales” from future quarters, CW3, a former Sipex

customer service supervisor, avers that the company had a backlog of orders. The weekly

“Backlog Report” allegedly showed each order and when the distributor expected it to be shipped,

taking into account the lead time to manufacture. If Sipex could beat the expected date, Sipex

would do so, shipping ahead of the expected date. Sometimes distributors accepted the premature

shipment. “In many cases, the entire order would be returned to the company because the

distributor simply would not accept it” (¶ 56). This would lead to filling out return authorization

forms. Sometimes Sipex told the distributor not to return the product but to keep it and not pay

for it until the original agreed-upon date (¶ 57). 

This allegation is a mixed bag. There is nothing wrong per se with sending a backlogged

product to a customer ahead of the expected schedule, at least when the customer acquiesced in

the original expected delay on account of a backlog and the lead time to manufacture. To

overcome the backlog and ship sooner can be good customer service; it avoids unwanted delay

for the customer. Even if the customer refuses to pay for early-shipped goods until the “agreedupon” date, if the obligation to pay is still firm, the sale conceivably can be booked on shipment

anyway. On the other hand, if the customer returns the goods as unwanted so early, then the sale

must be undone or so the complaint alleges. The problem is that CW3 scrambles the various

possibilities into a single souffle. It is too hard to divine how much, even roughly, was improper. 

The Form 8-K did not acknowledge any problem on this issue. The allegations in the complaint

on this point are insufficient. 

In summary, a strong inference of fraud by CEO Maghribi and the company has been

shown with respect to improper revenue recognition during the class period. This is based on the

admission by Sipex that the financials were materially misleading, the recent forced resignation of

CEO Maghribi, the recent muscular corporate internal reforms including pervasive ethics training

and annual certifications, the recent admission that the company’s revenue recognition practices

had been at fault, and the $350,000 sham sale engineered by CEO Maghribi himself. 

These circumstances are sufficient to allow this case to survive under the PSLRA. On the

other hand, this order holds that the allegation as to one alleged accounting practice (early

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United States District Court

For the Northern District of California

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shipments) is not specific and convincing on this record. Given that the complaint has largely

been sustained, discovery will be allowed into all of the alleged revenue practices. To try to carve

out the issue of early shipments out of discovery would invite interminable discovery disputes. 

As to defendant Phillip A. Kagel, the complaint must be dismissed. He was with the

company as its CEO for 14 months (February 2003 through April 2004). He resigned eight

months before CEO Maghribi. He was not fired by the board (as far as we can tell from the

complaint). Nor was he involved in the $350,000 sham sale. He was not subjected to the ethics

re-education and retraining in 2005. Presumably, he had something to do with the revenue

recognition while he was on board but given the lack of detail as to his involvement, a strong

inference of fraud is impossible to draw against Mr. Kagel at this stage. His motion do dismiss is

GRANTED with leave to amend within fourteen calendar days. Please do not ask for an extension

without very good cause. 

IT IS SO ORDERED.

Dated: November 17, 2005. 

WILLIAM ALSUP

UNITED STATES DISTRICT JUDGE

Case 3:05-cv-00392-WHA Document 117 Filed 11/17/05 Page 5 of 5