Opinion ID: 198674
Heading Depth: 2
Heading Rank: 2

Heading: Indirect Evidence of Scienter

Text: 95 There is also indirect evidence from which plaintiffs say scienter can be inferred. Defendants, or so the complaint alleges, knew the company was in trouble because they knew that Microsoft would have, as an integral part of its Windows 95 package, a product that would compete with FTP's wares. Purchasers of Windows 95 would therefore have no reason to purchase FTP's product. Before and during the Class Period (July 14, 1995, to January 3, 1996), FTP engineers repeatedly warned management of this competitive threat. Indeed, certain large orders, such as a $10 million order by the French Post Office, were cancelled. Plaintiffs allege that FTP's management responded through two strategies, channel stuffing and contingent sales, which artificially inflated the company's revenues.
96 Channel stuffing means inducing purchasers to increase substantially their purchases before they would, in the normal course, otherwise purchase products from the company. It has the result of shifting earnings into earlier quarters, quite likely to the detriment of earnings in later quarters. There is nothing inherently improper in pressing for sales to be made earlier than in the normal course, and we do not understand plaintiffs' complaint to make any such claim. Plaintiffs make use of the channel stuffing allegations in a different way. They say evidence of channel stuffing supports their contention that management knew that revenues during the Class Period would be low and attempted to hide that fact by shifting income through channel stuffing (which remained undisclosed) and by artificially inflating income through improper revenue recognition. In this context, the channel stuffing evidence has some probative value. 16 But that value is weak. Unlike altering company documents, there may be any number of legitimate reasons for attempting to achieve sales earlier. Thus, it does not support a strong inference of scienter.
97 Plaintiffs allege that the financial statements included in FTP's Form 10-Q report for the third quarter of 1995 were prepared in violation of GAAP and contained improperly inflated revenues and earnings. Specifically, plaintiffs claim that FTP recognized revenues from sales that included a right of return, which did not meet the requirements for revenue recognition set forth in FAS 48. When a buyer has the right to return a product, FAS 48 prohibits the seller from recognizing income from the sale unless six conditions are met. See Statement of Financial Accounting Standards No. 48, ¶ 6 (Fin. Accounting Standards Bd., June 1981). 98 Plaintiffs focus on three of the six FAS 48 conditions: that the buyer's obligation to pay the seller is not contingent on resale of the product; that the seller does not have significant obligations for future performance directly to bring about resale of the product by the buyer; and that the amount of future returns can be reasonably estimated. See id. If any of the conditions are not met at the time of the sale, sales revenue cannot be immediately recognized. See id. 99 Plaintiffs allege that during the Class Period FTP recorded as sales transactions including a right of return that violated all three of the above conditions. Plaintiffs claim FTP induc[ed] distributors to purchase more product than they needed with the promise that they could return the product if it were unsold . . . . [S]ubsequently, a material portion of these 'sales' were either returned in the fourth fiscal quarter of 1995 or remained with distributors, but were unpaid for. Plaintiffs contend that [u]nder certain circumstances, the distributor could defer payment until FTP's or its own sales force had booked a sale to an ultimate customer for the products. FTP, however, would not receive payment until the distributor was in a position to book the sale and ship the product and receive payment from the end user . . . . Furthermore, due to the constantly changing competitive environment and the release of Microsoft's 'Windows '95', FTP had no way to reasonably estimate returns. Finally, even if all the conditions for immediate revenue recognition are met, FAS 48 requires that the seller reduce sales revenue and cost of sales reported in the income statement to reflect estimated returns. See id. ¶ 7. Plaintiffs allege that FTP violated this by failing to adequately reserve for returns. 100 Violations of GAAP standards such as FAS 48 could provide evidence of scienter. See Malone v. Microdyne Corp., 26 F.3d 471, 478-79 (4th Cir. 1994). To support even a reasonable inference of scienter, however, the complaint must describe the violations with sufficient particularity; a general allegation that the practices at issue resulted in a false report of company earnings is not a sufficiently particular claim of misrepresentation. Gross v. Summa Four, Inc., 93 F.3d 987, 996 (1st Cir. 1996) (quoting Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 362 n.5 (1st Cir. 1994)). Here, as the district court correctly concluded, the complaint clearly falls short. The allegations in the complaint do not include such basic details as the approximate amount by which revenues and earnings were overstated, see Gross, 93 F.3d at 996; the products involved in the contingent transactions, cf. Malone, 26 F.3d at 476-77 (products that were sold with rights of return specifically identified); the dates of any of the transactions; or the identities of any of the customers or FTP employees involved in the transactions. We do not say that each of these particulars must appear in a complaint, but their complete absence in this case is indicative of the excessive generality of these allegations. 101 As part of their opposition to defendants' renewed motion to dismiss, plaintiffs attempted to introduce evidence of four alleged contingent transactions drawn from defendants' automatic disclosure. The district court, however, refused to take this new evidence into consideration in its ruling. The court reasoned that there would have been no disclosure but for the white-out allegations, because the complaint would have been dismissed at the outset; the white-out allegations proved insubstantial, even with the benefit of disclosure; and therefore the remainder of the complaint should be judged without the additional evidence obtained through disclosure. We need not decide whether the district court's refusal to consider the additional evidence was correct, because we believe that plaintiffs' additional evidence would not have sufficed to prevent dismissal. 102 Plaintiffs identify four sets of transactions from the third quarter of 1995 that allegedly involve improperly booked revenue. Plaintiffs present invoices, purchase orders, and other documentation that show, they contend: (a) a set of transactions totaling $678,000 with a distributor, Merisel, in which Merisel was not obliged to pay for the product; (b) a $705,250 transaction with reseller CC-OPS in which CC-OPS was given an unlimited right to return the product; (c) a $1.14 million transaction with reseller Afina Sistemas that involved the sale of an FTP product that did not yet exist; and (d) a $416,325 transaction with reseller Force 3 that was contingent upon Force 3 receiving a government contract. 103
104 The Merisel allegations involve one $130,078 transaction in August 1995 and two transactions in late September 1995 totaling $548,192. Plaintiffs claim that the August transaction, for which FTP issued an invoice, was not a true sale but a stock rotation, in which FTP replaced outdated products in Merisel's inventory at no charge. Plaintiffs point to a credit issued to Merisel by FTP in mid-October for the full amount. Less detail is provided concerning the September transactions. To support their contention that those transactions were improperly booked contingent sales, plaintiffs proffer three items: the $548,192 posted to accounts receivable on September 29; the fact that $494,872 remained unpaid as of December 31; and the agreement between Merisel and FTP, which states that Merisel will pay FTP for all copies of FTP's products sub-licensed by Merisel and its dealers. 105 A possible -- though far from necessary -- conclusion is that the August transaction was an exchange of new products for old improperly booked as a sale, as the original Merisel purchase order contains the notation [o]ffsetting order f. stockrotation (sic). The September transactions, on the other hand, are described in insufficient detail to support plaintiffs' allegations. The mere existence of an overdue receivable does not support an inference that the original transaction was booked as a sale in violation of GAAP. 106
107 The CC-OPS allegation concerns a September 29 order for $705,250 of FTP products, which FTP immediately booked as a sale. A letter from FTP's sales director for the Americas apparently accompanied the invoice. The letter stated that it was FTP's policy to allow[] large or frequent customers to return product without contingency within 60 days of receipt of order. Large customers were defined as those generating over $100,000 per year. A copy of the original letter is not present in the invoice file. On November 27, CC-OPS faxed a copy of the letter back to FTP, and FTP extended the right of return from 60 to 90 days. This revised letter is present in the file. Shortly after the return period was lengthened, FTP issued a credit for the full amount of the invoice and authorized the return of the product. On the original invoice is written: Credit per Jack Geraghty. Not recognizable revenue. 17 108 Plaintiffs charge that the initial booking of revenue from this transaction violated GAAP; that the letter indicates that FTP had a policy of granting unlimited return rights to its customers; and that the absence of the original September 29 letter from the file indicates that FTP was attempting to conceal the existence of return rights. However, FAS 48 permits sellers to recognize sales that include a right of return, so long as the required conditions are met and the seller establishes a reasonable reserve for returns. The granting of a right of return in a particular transaction, or even a general policy of granting return rights, does not per se mean that revenue cannot be recognized at the time of sale. Plaintiffs merely make an allegation that FTP failed to adequately reserve and materially overstated FTP's revenues. Without any information on FTP's experience with past return rates, the size of its reserve for returns, or how the reserve changed over time, it is difficult to infer that FTP's revenue recognition decisions were unreasonable enough to violate GAAP, or that they give rise to a strong inference of scienter. 'Generally accepted accounting principles,' . . . tolerate a range of 'reasonable' treatments, leaving the choice among alternatives to management. Thor Power Tool Co. v. Commissioner of Internal Revenue, 439 U.S. 522, 544 (1979). 109
110 The Afina Sistemas (Afina) allegation involves two purchase orders totaling $1.14 million issued on September 28. The orders were for 200,000 copies of FTP's Internet browser, custom made for an Afina client. FTP booked the entire amount as revenue on September 29 and carried the amount as an account receivable throughout the fourth quarter. Plaintiffs claim that this revenue was improperly booked because the version of the browser ordered by Afina was then still under development. An internal FTP document indicates that the test version of the Spanish edition of the browser was not scheduled to be completed until late October. Plaintiffs also point to notations reading DO NOT SHIP PRODUCTS on documents attached to each invoice. 111 This transaction is difficult to classify. This appears to be one part of a larger undertaking (the Telefonica project referred to on the Afina purchase order) about which plaintiffs present only fragmentary information. It is not clear that the custom version of FTP's browser referred to in Afina's purchase order is the same as the Spanish version listed on FTP's development schedule. Furthermore, marking DO NOT SHIP prominently on documents seems an odd way to conceal an improperly booked sale from auditors. Finally, the fact that an overseas customer with 90 days to pay has not paid after 94 days is not highly suspicious. It is possible to infer, however -- at least tentatively -- that this transaction should not have been booked as a sale in September. It is a leap from there to a strong inference of scienter. 112
113 The Force 3 allegations concern a purchase order for $416,325 issued on September 30, which stated on its face that it was contingent on Force 3's receipt of a government contract. FTP nonetheless immediately recorded the entire amount as an account receivable. On December 29, FTP issued Force 3 a credit for the full amount. The same day, Force 3 sent FTP a new purchase order for the same products it ordered on September 30, but this purchase order did not refer to any contingency. FTP issued a new invoice and again booked the amount as a sale. The original booking of this sale in September appears to have violated the requirement in FAS 48 that the buyer's obligation to pay the seller is not contingent on resale of the product. 114 At best, plaintiffs' additional evidence supports an inference that FTP improperly recognized from $416,000 to $1.55 million in revenue in the third quarter of 1995. Because FTP reported overall revenue during the quarter of $37.1 million, these transactions do not support a strong inference of scienter. 18 It is equally possible to conclude that FTP made some incorrect accounting decisions regarding a limited number of transactions. Seeing fraud, however, requires too great of an inferential leap. In short, even when viewed in combination with plaintiffs' other allegations, plaintiffs' additional evidence does not support a strong inference of scienter, and thus the district court's decision not to consider the evidence could not have affected the outcome of the motion to dismiss.
115 The allegations of insider trading do not, either alone or together with the other allegations, suffice. The individual defendants sold FTP common stock during the Class Period. For example, Zirkle sold 40,000 shares on July 21, 1995 at a price of $26.27 per share, for total proceeds of $1,050,800. Goodnow sold 40,000 shares on July 27 at a price of $29.00 per share, for a total price of $1,160,000. Last, on August 2, 1995, Charlotte Evans sold 200 shares at $28.50 per share, for a total of $57,000. All three defendants sold stock later in the Class Period as well. 116 We first look at context. The timing does not appear very suspicious. None of these three key players sold at the high points of the stock price. Each waited to sell until after FTP announced a corporate reorganization on July 14, an announcement which caused the price of the stock to fall. Each sold some stock before an allegedly manipulated analyst's report from Brookehill Equities recommended FTP stock as a long-term buy on August 3, 1995, and before a favorable Cowen & Co. report on December 1, 1995. 117 The total sum of sales involved -- over $23 million during a six month period -- could be suspicious, but a closer look provides ready explanations. Goodnow, as plaintiffs allege, retired on October 26, 1995, from his position as vice president, CFO, and treasurer. His sale of stock in July occurred not long before he left the company. He also sold a considerable number of shares after he left the company -- 690,000 shares accounting for $19 million out of his total of almost $20.2 million in sales during the Class Period. The vast majority of the $23 million in sales by the individual defendants, more than $20 million worth, were by one individual who was leaving the company, and more than $19 million was after that individual had left the company. It is not unusual for individuals leaving a company, like Goodnow, to sell shares. Indeed, they often have a limited period of time to exercise their company stock options. As to the others, the sales do not reflect either unusual sales or sales made before a big event unknown to the public. Selling after delivering news that causes a company's stock price to go down is not suggestive of withholding information. But that is what happened here. Plaintiffs provided no information on sales by corporate insiders at times outside the Class Period, so there is no comparison point. 118 Although the total sum involved was large, the district court correctly concluded that plaintiffs produced no evidence that the trading was out of the ordinary or suspicious. Absent additional evidence, it is not possible to draw a strong inference of scienter based on improper trading on material, non-public information. 119