Opinion ID: 1038518
Heading Depth: 2
Heading Rank: 2

Heading: Allegations Supporting Scienter

Text: Ricker’s complaint primarily relies on information provided by Witness 3, a confidential witness and former employee in Zoo’s accounting department.2 Witness 3 alleged that problems 2 “While . . . anonymous sources are not altogether irrelevant to the scienter analysis,” conclusory or vague allegations do not deserve much weight. Ley v. Visteon Corp., 543 F.3d 801, 811 (6th Cir. 2008) (citation omitted), abrogated on other grounds by Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1323 25 (2011), as recognized in Frank v. Dana Corp., 646 F.3d 954, -3- No. 12-3951 Ricker v. Zoo Entm’t Inc. with one of Zoo’s largest customers, Cokem, led Zoo to improperly recognize revenue. Witness 3 maintained that payments received from Cokem were always past due, and that she emailed Fremed and Rosenbaum, relaying that Cokem’s owner was “very difficult to deal with[,] . . . never paid on time and demanded rebates and discounts well beyond” those afforded to other companies. (R. 14, Am. Compl. ¶ 32.) Despite Witness 3’s attempts to prompt Cokem to pay its bills, she alleges that Rosenbaum cut deals with Cokem that forced Zoo to collect far less than Cokem owed. This prevented her from accurately projecting cashflow and hindered her ability to evaluate important billing and collection matters. Witness 3 further claims to have alerted Fremed and Seremet to the collection problems, emailing them daily “Year to Date Sales” reports that monitored what Zoo billed, the cash it received, and outstanding accounts receivable. Witness 3 stated that she told Fremed and Seremet about the inaccuracies in her cashflow projections, warning Seremet to “look closely at Rosenbaum and Cokem.” Also, “[d]uring the Class Period, Witness 3 remembers hearing discussions of Company employees, questioning whether sales to Cokem were final” and stretching to “mak[e] the numbers . . . [by] push[ing] product with unusual sales enhancements.” Even as Cokem’s share of Zoo’s net revenue grew from 14% in 2008 to 40% in 2010, Ricker alleges that Seremet and Fremed allowed Rosenbaum, the Cokem account’s primary contact and 960 62 (6th Cir. 2011). Here, Witness 3’s employment in Zoo’s accounting department positioned her to learn of the facts now alleged. The district court therefore credited Witness 3’s perceptions more than the anonymous source in Ley. See also Halford v. AtriCure, Inc., 2010 WL 8973625, at ,  12 (S.D. Ohio Mar. 29, 2010) (crediting six confidential witnesses’ allegations after examining their job descriptions to ascertain whether any could have gained first-hand knowledge of the facts attributed to him or her). -4- No. 12-3951 Ricker v. Zoo Entm’t Inc. salesperson, to “maintain strict control over the relationship and contact with Cokem.” This delegation of control, Ricker reasons, coupled with Seremet and Fremed’s purported knowledge of problems with the Cokem account, demonstrates that Zoo “should have known that revenue numbers for Cokem were highly suspect.” When the time came to restate revenue, however, Witness 3 played no role; Zoo “excluded” her from its restatement process.
Ricker next alleges that an Atari lawsuit filed against (and settled by) Zoo during the class period corroborates Zoo’s alleged revenue-recognition problems with Cokem and further supports scienter. Incorporating allegations from Atari’s complaint, Ricker explains that Zoo contracted with Atari to advance funds enabling Zoo to fulfill existing video-game purchase orders. In exchange, Zoo would remit payment for those purchase orders to Atari, including $1.6 million Cokem owed. Atari went unpaid and sued, claiming one of two things had occurred. Either Zoo received money for the purchase orders and kept it, or one or more of Zoo’s customers cancelled purchase orders covered by the Atari agreement and Zoo retained Atari’s advance.
Ricker alleges that Zoo’s awareness of its weak internal controls particularly the lack of adequate finance staff supports a strong inference that it recklessly issued the 10-Qs. Zoo disclosed the following in its challenged 10-Qs: -5- No. 12-3951 Ricker v. Zoo Entm’t Inc. Our management has determined that we have a material weakness in our internal control over financial reporting related to not having a sufficient number of personnel with the appropriate level of experience and technical expertise to appropriately resolve non-routine and complex accounting matters or to evaluate the impact of new and existing accounting pronouncements on our consolidated financial statements while completing the financial statements close process. We are committed to addressing this in 2010 and we will reassess our accounting and finance staffing levels to determine and seek the appropriate accounting resources to be added to our staff to handle the existing workload. (E.g., R. 17-7, Zoo 2010 Q1 10-Q at 7.) Ricker alleges that because revenue recognition is “routine and non-complex,” this disclosure should not shield Zoo’s revenue-recognition error; Zoo acted with scienter by failing to also “alert investors that the most basic accounting matters were, themselves, suspect.”
Zoo restated 3% of revenue for the first quarter of 2010, 6% for the second quarter of 2010, and 2% for the third quarter. The reduced revenues negatively affected diluted-net-income per share and diluted-net-loss per share. The restatement caused Zoo’s diluted-net-income per share to fall from $0.10 to $0.01 for the first quarter of 2010; diluted-net-loss per share to rise from $0.11 to $0.22 during the second quarter of 2010; and diluted-net-income per share to fall from $0.04 to $0.01 during the third quarter of 2010. Ricker acknowledges the modest level of these revenue restatements, but posits that the “relatively small overstatement of revenue” caused “a massive overstatement of net income and . . . [earnings per share],” allowing Zoo the “ability to manipulate -6- No. 12-3951 Ricker v. Zoo Entm’t Inc. revenue numbers . . . and report positive earnings.” This overstatement of income and earnings per share, Ricker argues, supports a strong inference of scienter.
Ricker alleges that because Zoo’s revenue-recognition policy tracked generally accepted accounting principles (“GAAP”), Zoo’s management knew how to properly recognize revenue, and their failure to do so here supports finding scienter.
To further support a strong inference of scienter, Ricker highlights the departures of three high-ranking Zoo officials after the restatement. First, Witness 3 alleged that Rosenbaum “left because he knew the Company was about to ask him to leave.” Second, director John Bendheim, a former member of Zoo’s Audit Committee, resigned. And third, within three months of the restatement, Chief Operating Officer Steve Buchanan left Zoo Publishing.
Ricker’s complaint also includes financial information that, he argues, demonstrates that Zoo’s “capital raise just happened to coincide with the near exhaustion of Zoo’s cash on-hand.” Without that capital, Zoo could not have funded the projects it outlined in the offering’s prospectus: $2 million to develop digital initiatives, $1.1 million to repay an advance, and $4.8 million in -7- No. 12-3951 Ricker v. Zoo Entm’t Inc. working capital. Though not expressly alleged in his complaint, Ricker concludes that, considering this information, Zoo was “motivated to commit fraud.” (Appellant Br. at 40 41.)