UNITED STATES DISTRICT COURTEASTERN DISTRICT OF NORTH CAROLINA
WESTERN DIVISION
)))Master File
IN RE: RED HAT, INC. SECURITIES LITIGATION ) No. 5:04-CV-473-BR)))
O R D E R
This matter is before the court on the 29 July 2005 motions by defendants to dismiss the
consolidated class action complaint under Fed. R. Civ. P. 12(b)(6). Lead Plaintiffs filed a joint
response in opposition to the motions. Defendants filed replies, and on 15 March 2006, Red Hat,
Inc. defendants filed a suggestion of subsequently decided authority pursuant to L. Civ. R. 7.1(g),
E.D.N.C. 1 This matter is ripe for disposition.
I. FACTUAL AND PROCEDURAL BACKGROUND2
Beginning on 14 July 2004, fourteen nearly identical proposed class action suits were filed
in this district alleging violations of the Securities Exchange Act of 1934 (“Exchange Act”) against
defendant Red Hat, Inc. (“Red Hat”), some of its senior officers and its auditor
PricewaterhouseCoopers (“PwC” or “PWC”). By order filed 8 September 2004, after a status
1 The case attached is a 13 March 2006 Wake County Superior Court order dismissing a shareholder derivativelawsuit against the individual Red Hat defendants in this case (as well as other defendants not parties to this case) forthe plaintiff’s failure to establish demand futility under Delaware law and because the plaintiff is no longer a shareholder.Att. at 1.
2 Because this matter is before the court on defendants’ motions to dismiss, “the court is required to accept astrue all well-pled allegations in the [c]omplaint, and to construe the facts and reasonable inferences from those facts inthe light most favorable to the plaintiff.” In re Humphrey Hospitality Trust, Inc. Securities Litigation, 219 F. Supp. 2d675, 681-82 (D. Md. 2002) (citing Ibarra v. United States, 120 F.3d 472, 473 (4th Cir. 1997)).
conference and upon joint motion of all parties to the actions, the court consolidated the cases with
the above-captioned case being the master case. By order filed 13 January 2005, the court appointed
several plaintiffs as Lead Plaintiffs in order to coordinate motions practice, discovery, settlement
negotiations, and trial preparation.
Lead Plaintiffs filed a consolidated amended class action complaint on 6 May 2005 alleging
claims for violations of Sections 10(b) and 20(a) of the Exchange Act, 15 U.S.C. §§ 78j(b) and
78t(a); Rule 10(b)(5) promulgated under Section 10 of the Exchange Act; and Section 304 of the
Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7243. Specifically, Lead Plaintiffs allege that Red Hat
reported revenue on sales contracts before the revenue was actually earned by recognizing revenue
on a monthly, rather than on a daily basis, and thus falsely inflated the revenue that was reported to
investors. 3 Am. Compl. ¶¶ 22-26. Lead Plaintiffs allege that this practice was in violation of
Generally Accepted Accounting Principles (“GAAP”) 4 and thus Red Hat’s quarterly and annual
financial statements filed with the SEC did not meet SEC regulations, which require that such
statements be prepared in conformity with GAAP. Id. ¶¶ 189-210. Lead Plaintiffs also allege that
Red Hat engaged in other tactics to falsely inflate revenue, such as “acquir[ing] other businesses
with the ‘100% purpose’ of assuming the revenues of the acquired companies in order to smooth
over dips in income . . . . [and] appease[] [shareholders] with a one-time injection of revenue[;]”
3 For purposes of the instant motion, Red Hat is engaged in the business of selling annual subscriptions for itscomputer operating system. Am. Compl. ¶¶ 21-22. Many customers sign subscription contracts at the end of a month,so, for example, if a contract is signed on August 28, Red Hat reported the income for the entire month of August, eventhough it only received income for the last four days of the month. Id. ¶¶ 26, 29-30. Lead Plaintiffs allege that “this hadthe effect of prematurely recognizing the quarterly revenue that was reported to investors.” Id. ¶ 26.
4 Although the court will not recite the details of Lead Plaintiffs’ allegations regarding GAAP violations, thecourt notes that Lead Plaintiffs cite to and quote extensively from several accounting publications. See Am. Compl. ¶¶196-203, 212-13, 220. Lead Plaintiffs also allege that the monthly revenue recognition violated PwC’s own accountingpolicy for recognizing revenue from software. Id. ¶ 253.
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“report[ing] forecasted subscriber contract renewal rates well over 75%, when, in reality, the actual
subscriber contract renewal rates never exceeded 50%[;]” and “recognizing a large quantity of
revenues in association with consulting hours that had not actually been worked.” Id. ¶¶ 32, 40, 46.
With regard to the individual Red Hat defendants, Lead Plaintiffs cite a “Former [Red Hat]
Managing Consultant/Director of Professional Services” who states that defendants Szulik and
Thompson, Red Hat’s Chief Executive Officer and former Chief Financial Officer/Executive Vice
President, respectively,
controlled “every single aspect” of Red Hat’s business, in that they “made all thedecisions.” . . . [A]lmost no decision “about anything” could be made at Red Hatwithout [their] . . . personal approval, and . . . “everything flowed up” with little orno delegation of authority. Moreover, if any Red Hat employee questioned anythingthat [d]efendants Szulik or Thompson did, “that person disappeared, fast.” TheFormer Director of Business Intelligence corroborated this, saying Defendant Szulikknew “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.”
Id. ¶ 302. Defendant Szulik “was constantly involved in debate regarding Red Hat’s renewal rates”
and “reportedly held regular ‘reverse sessions’ to address and explore any and all issues associated
with the subscription renewal rates.” Id. ¶ 303. Defendant Szulik signed Red Hat’s quarterly and
annual SEC forms (“Forms 10-Q and 10-K”) for fiscal years 2003 and 2004, which were ultimately
restated and form a basis of this lawsuit. Id. ¶¶ 118, 134, 147, 161, 174. Defendant Thompson “had
direct knowledge of the Company’s subscription renewal forecasts” because “sales personnel
forecasted how many accounts were likely to renew for a given period” and “rolled the reports up
to Defendant Thompson directly. In addition, according to the Former Director of Professional
Services, Defendant Thompson knew that Red Hat had an established history of manipulating its
revenues in order to achieve its quarterly revenue goals . . . .” Id. ¶ 304. Defendant Thompson also
signed Red Hat’s Forms 10-Q and 10-K for fiscal years 2003 and 2004. Id. ¶¶ 118, 134, 147, 161,
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174. Defendant Webbink was Red Hat’s General Counsel, and his “signature was definitely
required in ‘all legal matters[,]’” including “sign[ing] off on ‘all customer contracts, big and small.’”
Id. ¶ 305. His “office was ‘right next to Thompson’s’ and . . . the two had a ‘visual’ of each other
throughout the day . . . . Webbink was a regularly interacting ‘peer’ to Szulik and Thompson . . . .”
Id. “As Red Hat’s Senior Vice President and Chief Operating Officer, Defendant Buckley had
significant control and input into Red Hat’s operations.” Id. ¶ 306. “As Red Hat’s . . . Executive
Vice President of Engineering, Defendant . . . Cormier’s role was to ‘get involved’ whenever there
were problems/issues that arose with large customer accounts . . . . Cormier was ‘not just a crisis
manager,’ and was involved in Red Hat’s customer management outside of just ‘dealing with
problems.’” Id. ¶ 3 07.
With regard to PwC, Lead Plaintiffs allege that it “actively assisted and participated, both
directly and knowingly, in Red Hat’s ongoing revenue recognition fraud.” Id. ¶ 63. Lead Plaintiffs
describe the relationship between the Raleigh PwC office (which had conducted the audits) and Red
Hat as “intertwined[,]” quoting a former Red Hat employee “who stated that Red Hat’s accounting
department employed ‘a lot of people’ who were formerly employed by PWC . . . .” Id. ¶ 65. The
same PwC audit partner (“Barber”) had been continuously assigned to the Red Hat account for the
five year period prior to the restatement, along “with the same PWC audit staff[.]” Id. ¶¶ 64, 67.
Red Hat’s former CFO, defendant Thompson, had worked with Barber at PwC, 5 along with several
other Red Hat employees not named as defendants. Id. ¶ 65, 67. Barber and his audit team were
5 Defendant Thompson was also previously employed at another large accounting firm, Arthur Andersen. Am.Compl. ¶ 218.
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frequently at Red Hat’s corporate office, and, according to a former Red Hat employee, 6 defendant
Thompson shared an April 2004 SEC inquiry with a PwC auditor who shared it with Barber. Id. ¶¶
67-68, 105. Lead Plaintiffs contend that “PWC had significant financial incentives to appease Red
Hat” because it “has been handsomely compensated throughout their [sic] engagement with Red
Hat[,] . . . . [earning] fees [which] are quite large, especially considering the fact that PWC’s office
in Raleigh is very small.” Id. ¶ 308-09.
When Congress passed the Sarbanes-Oxley Act in July 2002, which required rotation of lead
auditors every five years, Red Hat would be “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 “had strong reasons to believe that the new auditor who would soon arrive at Red Hat would be
a stranger . . . .” Id. ¶¶ 71, 75. Accordingly, Lead Plaintiffs allege, the Red Hat individual
defendants “began to illegally sell millions of dollars worth of their personal stock, with a staggering
amount of sales taking place in February 2004 and continuing through May 2004, all of which
encompassed the quarter which the new auditor would be addressing.” Id. ¶ 78. 7 Defendant
Thompson resigned on 14 June 2004, less than two weeks after the new PwC audit partner (“Petri”)
from PwC’s Boston office began his review of Red Hat’s books and “‘just three days before the
6 The employee is identified in the complaint as a “Former Treasurer.” Red Hat states that the only treasurerbetween 2001 and 2004 was defendant Thompson and he “did not privately inform plaintiffs that he was party to fraud. . . .” Red Hat Br. at 11. Lead Plaintiffs state that the employee “mistakenly identified in the [c]omplaint” as a treasurer“had a high-level position in the finance department at Red Hat and reported to [d]efendant Thompson during the ClassPeriod, but . . . he was not the [c]ompany’s [t]reasurer” and identify him in their brief in opposition to the instant motionsas a “Former Finance Executive.” Pls.’ Br. Opp. at 16 & n.12.
7 Lead Plaintiffs go into significant detail regarding individual Red Hat defendants’ sales of stock elsewherein the complaint, Am. Compl. ¶¶ 273-79, and quote a “Former Red Hat Independent Contractor PrincipalConsultant/Program Manager” as saying that the “significant stock sales [by the individual Red Hat defendants] did not‘sit right’ with him or with his Red Hat colleagues[,]” id. ¶ 280. In short, Lead Plaintiffs state that the six individual RedHat defendants sold almost 6 million shares of Red Hat stock for approximately $94,055,651, making much more moneythan through their base salaries and bonuses. Id. ¶¶ 271(a), 285-94.
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company [was] scheduled to report fiscal 2005 first-quarter earnings . . . . ’” 8 Id. ¶¶ 80, 82-83. On
16 June 2004, “Petri informed Red Hat management, including [d]efendant Thompson . . . , that he
wanted Red Hat to change the Company’s revenue recognition practice from a monthly basis to a
daily basis.” Id. ¶ 89. Using daily revenue recognition, Red Hat’s reported fiscal 2005 first-quarter
revenues were $41.6 million, “short of the Company’s guidance of $42.5-43.5 million and consensus
expectations of $43 million[,]” and Red Hat’s stock dropped 10.23 percent. Id. ¶¶ 91-92. Although
he was no longer assigned to Red Hat’s audit team, Barber continued to frequently travel to Red Hat
in late June and early July 2004, resulting in his being “admonished” by “senior PWC personnel”
and instructed not to return to Red Hat. Id. ¶¶ 96-98.
On 13 July 2004, “Red Hat revealed to the public that it planned to restate its audited
financial statements for the fiscal years” 2002 through 2004 as well as its fiscal 2005 first quarter
as a result of Petri’s decision to change Red Hat’s revenue recognition practices, and Red Hat’s
stock dropped 22.7 percent. Id. ¶¶ 99, 106. Filed with the SEC on 4 August 2004, Red Hat’s
restatement form (“Form 10-K/A”) revealed various discrepancies in Red Hat’s Forms 10-Q and 10-
K for fiscal years 2003 and 20049 regarding Red Hat’s revenue, profit, income and loss. Id. ¶¶ 118,
125, 134, 139, 147-48, 151, 161, 165, 174, 176, 179-80. Attached to Red Hat’s 2003 and 2004
Forms 10-K were statements by PwC that the forms “‘present fairly, in all material respects, the
8 Lead Plaintiffs quote a “Former [Red Hat] Regional Account Manager” as stating that “[h]e and his fellowsales personnel believed that Defendant Thompson had resigned because he was aware of the impending earningsrestatement announcement and the negative impact this would invariably have on Red Hat’s stock price.” Am. Compl.¶ 84.
9 The complaint only highlights discrepancies in Red Hat’s Forms 10-Q and 10-K for third quarter 2003, firstand third quarters 2004, and fiscal years 2003 and 2004, although Lead Plaintiffs allege that Red Hat’s “method ofrecognizing revenue from subscriptions . . . had been consistently applied” since fiscal year 2000, and “[t]he Companyhas not revealed, and [Lead] Plaintiffs have no way of knowing, what impact the restatement had on results for fiscalyears 2001 and 2000, going all the way back to the Company’s IPO in August 1999.” Am. Compl. ¶ 191.
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financial position of Red Hat, Inc. . . . . based on our audits . . . . conducted . . . in accordance with
auditing standards generally accepted in the United States of America . . . . ’” Id. ¶¶ 13 8, 178. Lead
Plaintiffs allege that Barber and PwC 10 violated Generally Accepted Accounting Standards
(“GAAS”) required by the SEC, including failure to maintain independence, negligently planning
and supervising Red Hat audits, failing to obtain a reasonable basis for audit opinions on Red Hat’s
financial statements, and by issuing unqualified audit reports on materially misstated financial
statements. Id. ¶¶ 222-68. Specifically, Lead Plaintiffs allege that given PwC’s status “[a]s one of
the largest audit firms in the world” and “the comprehensive services it provided to Red Hat, over
the years and its experience in the computer software/technology industry[,]” “PwC . . . possessed
knowledge or w[as] severely reckless in not possessing knowledge of that [sic] Red Hat was . . . not
in compliance with GAAP” and “knew or recklessly disregarded that Red Hat’s financial statements
were materially false and misleading . . . in violation of GAAP and SEC rules.” Id. ¶¶ 223, 232,
235.
II. DISCUSSION
A. § 10(b) and Rule 10(b)-5 Claims
To state a claim of fraud under Section 10(b) of the Exchange Act and Rule 10b-5
thereunder, Lead Plaintiffs must demonstrate that
(1) the defendant made a false statement or omission of material fact (2) withscienter (3) upon which the plaintiff justifiably relied (4) that proximately caused theplaintiff’s damages. If a reasonable investor, exercising due care, would gather afalse impression from a statement, which would influence an investment decision,then the statement satisfies the initial element of a § 10(b) claim.
10 Lead Plaintiffs allege that “[t]he failures of Barber, a PWC engagement partner and managing partner ofPWC’s Raleigh, North Carolina office, to comply with GAAS in the conduct of the audit bind and are imputed to PWC.”Am. Compl. ¶ 264.
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Phillips v. LCI Int’l, Inc., 190 F.3d 609, 613 (4th Cir. 1999) (citations omitted).
The allegations in the complaint must further meet the pleading requirements of both Fed.
R. Civ. P. 9 which requires “all averments of fraud or mistake . . . [to] be stated with particularity”
and the Private Securities Litigation Reform Act (“PSLRA”), which “heighten[s] the requirements
of Rule 9(b) for pleading scienter . . . [and] requires that a complaint . . . state with particularity facts
giving rise to a strong inference that the defendant acted with the required state of mind.” In re
Visual Networks, Inc. Sec. Litig., 217 F. Supp. 2d 662, 665-66 (D. Md. 2002) (quotations and
alteration omitted) (citing 15 U.S.C. § 78u-4(b)(2); In re Criimi Mae, Inc. Sec. Litig., 94 F. Supp.
2d 652, 656-57 (D. Md. 2000)).
1. Red Hat Defendants
Red Hat defendants contend that the amended complaint must be dismissed because Lead
Plaintiffs have failed to plead facts supporting a strong inference of scienter. 11 Red Hat Br. at 9.
The Fourth Circuit has adopted a standard as to what a “strong inference” meanswithin the PSLRA. In Ottmann[ v. Hanger Orthopedic Group, Inc. 353 F.3d 338 (4thCir. 2003)], the Fourth Circuit held that courts should employ a case-specificanalysis in examining scienter pleadings. Ottmann, 353 F.3d at 345. In addition,“courts should not restrict their scienter inquiry by focusing on specific categoriesof facts, such as those relating to motive and opportunity, but instead should examineall of the allegations in each case to determine whether they collectively establish astrong inference of scienter. And, while particular facts demonstrating a motive andopportunity to commit fraud (or lack of such facts) may be relevant to the scienterinquiry, the weight accorded to those facts should depend on the circumstances of
11 Red Hat defendants also briefly argue that because defendant “Thompson disclosed to the public on March23, 2003 – more than one year before the restatement – that Red Hat’s subscription ‘revenues are recognized monthly[,]’”Red Hat Br. at 23-24 (quoting Am. Compl. ¶ 133), Lead “Plaintiffs have alleged no fraud.” Red Hat Reply at 1. Thequote from defendant Thompson in its entirety (as alleged by Lead Plaintiffs) states that “as you look at our balance sheetand our deferred revenue balance, our revenues are recognized monthly, and our deferred revenues are driven by thepayment terms and billing terms we have with our customers, so the growth in deferred revenue relates to both the timingof the bookings of subscriptions during the quarter and how much the customers agree to pay up front versus what theydecide to pay quarterly.” Am. Compl. ¶ 133 (emphases added). Drawing inferences in favor of Lead Plaintiffs, thisseems to indicate that defendant Thompson stated that Red Hat recognized revenue only when it was actually received,but in actuality, as Lead Plaintiffs allege, Red Hat recognized revenue prematurely.
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each case.” Id. at 345-46. The Fourth Circuit has held that the required state ofmind, or scienter, for securities fraud liability is recklessness or intentionalmisconduct. See Ottmann, 353 F.3d at 344. Recklessness must be based on “an actso highly unreasonable and such an extreme departure from the standard of ordinarycare as to present a danger of misleading the plaintiff to the extent that the dangerwas either known to the defendant or so obvious that the defendant must have beenaware of it.” Phillips, 190 F.3d at 621; accord In Re MicroStrategy[, Inc. Sec. Litig.], 115 F. Supp. 2d [620,] 633 [(E.D. Va. 2000)]; Arnlund v. Deloitte & Touche LLP, 199 F. Supp. 2d 461, 474 (E.D. Va. 2002).
In re Cable & Wireless, PLC, 321 F. Supp. 2d 749, 761 (E.D. Va. 2004).
Examining all of the allegations in the amended complaint to determine whether they
collectively establish a strong inference of scienter, the court concludes that Lead Plaintiffs have
made the following allegations with sufficient specificity which, in combination, are sufficient to
withstand the motion to dismiss as to Red Hat and the individual defendants Thompson and Szulik.
a. revenue recognition in violation of GAAP
Lead Plaintiffs have alleged that Red Hat improperly recognized revenue before it was
earned in clear violation of GAAP. “Specific attributes of a GAAP violation may give rise to a
stronger, or weaker, inference of scienter . . . . [V]iolations involving the premature or inappropriate
recognition of revenue suggest a conscious choice to recognize revenue in a manner alleged to be
improper, and may therefore support a stronger inference of scienter.” In re Baan Co. Sec. Litig.,
103 F. Supp. 2d 1, 21 (D.D.C. 2000) (citations omitted); see also In re MicroStrategy, 115 F. Supp.
2d at 638 (same); In re Winstar Commc’ns, No. 01 CV 3014(GBD), 2006 WL 473885, *7 (S.D.N.Y.
Feb. 27, 2006) (same). Lead Plaintiffs’ allegations regarding Red Hat’s GAAP violations are further
strengthened by several other allegations: the prior employment of defendant Thompson (a certified
public accountant) as a “Senior Manager” at Andersen, LLP and “Technology Partner” at PwC; the
almost immediacy with which the new auditor recognized the revenue recognition issues and
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required that prior reports be restated; and defendant Szulik’s announcement during an interview
that Red Hat would not be issuing any restatements on the same day that the new PwC auditor told
Red Hat that it would have to change its revenue recognition method and restate prior financial
reports. Am. Compl. ¶¶ 13, 90, 89, 94. See, e.g., Arnlund, 199 F. Supp. 2d at 482 (“An inference
of scienter can be supported by the temporal relationship among several events.”).
b. insider trading by individual Red Hat defendants
Lead Plaintiffs have alleged that individual Red Hat defendants sold between 21.75% and
76% of their share holdings during the Class Period for collective proceeds of approximately
$94,055,651. Specifically with regard to defendants Szulik and Thompson, Lead Plaintiffs have
alleged that they sold $22 million and $2.9 millon respectively in stock during the Class Period,
when their annual salaries were $250,000 and $350,000 respectively. Am. Compl. ¶ 79. The court
concludes that Lead Plaintiffs have successfully alleged “‘that the trades were made at times and in
quantities . . . suspicious enough to support the necessary strong inference of scienter. ’” In re
MicroStrategy, 115 F. Supp. 2d at 643-44 (E.D. Va. 2000) (quoting In re Burlington Coat Factory
Sec. Litig., 114 F.3d 1410, 1424 (3d Cir. 1997)). Although Red Hat defendants suggest that “their
trading can be explained by plausible but innocuous reasons” including the vesting of stock options,
strike prices and Rule 10b5-1 trading plans, Red Hat Br. at 16, 20, the court finds such arguments
are more appropriate at a later stage of the proceedings than on a motion to dismiss. See In re
Orbital Sciences Corp. Sec. Litig., 58 F. Supp. 2d 682, 687 (E.D. Va. 1999) (defendants may
ultimately “provide an explanation for . . . [insider] trading activity” which would make plaintiffs’
other allegations “innocuous[, b]ut at this stage of the case and for the purposes of a motion to
dismiss, . . . the unusual insider trading alleged in the . . . [c]omplaint suffices to create a strong
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inference of scienter”) (citing Rubinstein v. Collins, 20 F.3d 160, 169 n.38 (5th Cir. 1994) (same));
see also In re Oxford Health Plans, Inc., No. MDL-1222 (CLB), 187 F.R.D. 133, 140 (S.D.N.Y. June
8, 1999) (“When all of the circumstances surrounding the Individual Defendants’ trading are known,
they may ultimately defeat the plaintiffs’ claims of individual insider trading and fraud. At this
point, however, the plaintiffs’ allegations of unusually large insider trades at suspicious times are
sufficient to create, along with the other allegations, a strong inference of scienter.” (citing San
Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris, 75 F.3d 801, 814-15 (2d Cir.
1996)); In re Orbital, 58 F. Supp. 2d at 686 & n.4 (holding lack of comparison to pre-class period
sales “irrelevant” because “the percentage of shares that [insiders] sold is large and unusual enough
to raise the requisite suspicion even without a record of previous trading activity.” (citing Stevelman
v. Alias Research Inc., 174 F.3d 79, 84-85 (2d Cir. 1999)). 12
In this case, . . . the Complaint goes well beyond merely alleging that [Red Hat]misapplied accounting principles and that, consequently, the Company had to restateits financials. It does so by alleging in some detail the magnitude of the restatedfinancials and the pervasiveness and repetitiveness of [Red Hat]’s GAAP violations;the simplicity of the accounting principles violated in this case; and the importanceof the contracts involved. This contextual background serves to amplify theinference of scienter to be drawn from [Red Hat]’s GAAP violations and restatementof financials.
12 These cases were decided before the enactment of the PSLRA. However, “[e]ven under the PSLRA, thedistrict court, on a motion to dismiss, must draw all reasonable inferences from the particular allegations in the plaintiff'sfavor, while at the same time requiring the plaintiff to show a strong inference of scienter.” Aldridge v. A.T. Cross Corp., 284 F.3d 72, 78 (1st Cir. 2002). See also Pirraglia v. Novell, Inc., 339 F.3d 1182, 1187-88 (10th Cir. 2003) (courtmust “evaluate plaintiff's suggested inference in the context of other reasonable inferences that may be drawn,” but its“role at the 12(b)(6) stage is simply to determine whether the plaintiff raises a strong inference of scienter . . . . Facedwith two seemingly equally strong inferences, one favoring the plaintiff and one favoring the defendant, it isinappropriate . . . to make a determination as to which inference will ultimately prevail, lest [the court] invade thetraditional role of the factfinder.”); Gompper v. VISX, Inc., 298 F.3d 893, 897 (9th Cir. 2002) (“District courts shouldconsider all the allegations in their entirety, together with any reasonable inferences [including inferences unfavorableto the plaintiffs] that can be drawn therefrom, in concluding whether, on balance, the plaintiffs’ complaint gives rise tothe requisite inference of scienter.”); Helwig v. Vencor, Inc., 251 F.3d 540, 553 (6th Cir. 2001) (“Plaintiffs need notforeclose all other characterizations of fact, as the task of weighing contrary accounts is reserved for the fact finder.Rather, the ‘strong inference’ requirement means that plaintiffs are entitled only to the most plausible of competinginferences.”). It does not appear that any courts in the Fourth Circuit have examined this issue.
11
In re MicroStrategy, 115 F. Supp. 2d at 636.
However, as to the individual Red Hat defendants, the court finds that Lead Plaintiffs have
only sufficiently alleged claims as to Thompson and Szulik. Simply put, the court finds that Lead
Plaintiffs have failed to allege that defendants Webbink, Buckley, and Cormier “played any role in
calculating or disseminating [Red Hat]’s earnings statements” and these three defendants did not
sign Red Hat’s SEC forms. Chu v. Sabratek Corp., 100 F. Supp. 2d 827, 838 (N.D. Ill. 2000)
(allegations regarding improper sales activity of officers “lack[] . . . the type of detail necessary to
support a strong inference of scienter” in absence of any connection between defendants who
engaged in challenged and company’s dissemination of earnings statements). Thus, the court will
dismiss these three defendants from this action.
2. PwC
In securities fraud claims against an auditor – claims which generally are based onthe fraud of others – the failure to identify problems with the defendant-company’sinternal controls and accounting practices does not constitute reckless conductsufficient for § 10(b) liability. What is required is for plaintiff to allege that theauditor’s conduct was highly unreasonable, representing an extreme departure fromthe standards of ordinary care and must, in fact, approximate an actual intent to aidin the fraud being perpetrated by the audited company. Furthermore, allegations ofGAAP [or GAAS] violations or accounting irregularities standing alone, areinsufficient to state a securities fraud claim. Only where such allegations are coupledwith evidence of corresponding fraudulent intent, might they suffice. Additionally,allegations that an auditor must have known, by virtue of its role as auditor, of thedefendant company’s role are insufficient by themselves to permit an inference ofrecklessness.
In re Royal Dutch/Shell Transport Sec. Litig., 380 F. Supp. 2d 509, 566 (D.N.J. 2005) (quotations,
citations and alterations omitted).
PwC contends that Lead Plaintiffs’ claims against it must be dismissed for three reasons.
First, PwC contends that the complaint does not allege that it made a false statement or omission of
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material fact because PwC did not audit Red Hat’s 2003 and 2004 Forms 10-Q, and any
misstatement on Red Hat’s 2003 and 2004 Forms 10-K (which were audited by PwC) is immaterial
as a matter of law because the restated Forms 10-K/A for those years showed insignificant
percentage differences, with a maximum difference in restated net income for 2004 of 1.9 percent.
PwC Br. at 8-9. Second, PwC contends that Lead Plaintiffs’ allegations regarding PwC’s profit
motive, PwC’s “prior and ongoing relationships with Red Hat personnel[,]” and PwC’s GAAS
violations fail to show sufficient scienter. Id. at 12-15. Finally, PwC contends that, to the extent
that Lead Plaintiffs attempt to assert a § 10(b) claim against PwC based on statements by other
defendants under an “aiding and abetting” theory, such claim was rejected by the Supreme Court
in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). Id.
at 14-15.
The court turns first to whether plaintiffs have alleged a misstatement for which PwC could
be held liable. The parties agree that the alleged misstatements at issue are Red Hat’s Forms 10-Q
and 10-K for 2003 and 2004. PwC Br. at 6-7; Lead Pls.’ Br. Opp. at 27-28; PwC Reply at 2 & n.1 .
As noted above, PwC contends that it did not review Red Hat’s Forms 10-Q and thus cannot be held
liable for any misstatement on them. Lead Plaintiffs contend that “[e]ach of Red Hat’s quarterly
filings on Form 10-Q incorporated the fraudulent annual 10-Ks by reference, and, as required by
federal regulation, PwC reviewed each of Red Hat’s quarterly filings.” Lead Pls.’ Br. Opp. at 28
(citing Am. Compl. ¶ 68, Rule 10-01(d) of Regulation S-X, and 17 C.F.R. § 210.10-01).
The court agrees with PwC that it cannot be held liable for any misstatement in the Forms
10-Q. To impose liability under § 10(b), PwC “must actually make a false or misleading statement
. . . . Anything short of such conduct is merely aiding and abetting, and no matter how substantial
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that aid may be, it is not enough to trigger liability under Section 1 0b.” Wright v. Ernst & Young
LLP, 152 F.3d 169, 175 (2d Cir. 1998). “A secondary actor cannot incur primary liability under the
[Securities Exchange Act of 1934] for a statement not attributed to that actor at the time of its
dissemination.” Id. “Thus, the misrepresentation must be attributed to that specific actor at the time
of public dissemination, that is, in advance of the investment decision.” Id. Although Lead
Plaintiffs now contend that PwC reviewed the Forms 10-Q and that those forms incorporate the
Forms 10-K by reference, the court does not find these allegations in the amended complaint, 13 and
even if it did, such allegations would be insufficient to hold PwC liable for any misstatement on the
Forms 10-Q. See In re The Warnaco Group, Inc. Sec. Litig. (II), 388 F. Supp. 2d 307, 313-14
(S.D.N.Y. 2005) (“liability may not generally attach to a public auditor for unaudited public
statements the company made[;]” even “allegations that accountant ‘merely reviewed and approved’
unaudited statements or was ‘instrumental in helping’ company prepare them are insufficient to
transcend the proscribed category of aiding and abetting liability under Section 10(b)”) (citations
omitted); Markewich v. Adikes, 422 F. Supp. 1144, 1147 (E.D.N.Y. 1976) (“Absent a specific
declaration of incorporation, a mere mention of the annual report does not incorporate it by
reference; otherwise, an annual report would automatically be incorporated by reference in any
proxy statement which ever recognized the existence of, or merely accompanies, an annual report.”
(citation omitted)).
With regard to any misstatements in the Forms 10-K, the court agrees with PwC that such
13 The amended complaint alleges only that defendants Szulik and Thompson certified the accuracy of theForms 10-Q (and is silent with regard to whether these reports incorporate the annual reports by reference), and that PwCissued auditor reports for the Forms 10-K. Am. Compl. ¶¶ 119, 138, 147, 161, 178.
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misstatements are insufficient to be material. 14 The materiality of a statement is based on the
magnitude of the event to which it is related, and the magnitude of the event is measured “in light
of the totality of the company activity.” Hillson Partners Ltd. Partnership v. Adage, Inc., 42 F.3d
204, 219 (4th Cir. 1994) (citation omitted) (statement that was only misleading as to 0.5 percent of
a company’s total revenues was immaterial as a matter of law); see also Smith v. Circuit City Stores,
Inc., 286 F. Supp. 2d 707, 720 (E.D. Va. 2003) (omission of cost which amounted to 0.01 percent
of company’s total revenue or 3.25 percent of net earnings is immaterial) (citing numerous cases).
In this case, the Form 10-K/A revealed differences in 2004 total revenues, gross profit, operations
income and net income ranging from 0.45 to 9 percent, 15 but no change in the net income per share.
See Am. Compl. ¶ 180; PwC Br. Exh. A at 53 (2004 Form K/A); 16 Glassman v. Computervision
Corp., 90 F.3d 617, 633 & n. 26 (1st Cir. 1996) (omitted information of 3 to 9 percent of actual
revenues was immaterial). Thus, “in light of the totality of the company activity[,]” and particularly
the lack of any effect on the net income per share, the court concludes that any misstatement by PwC
was immaterial as a matter of law, and it must be dismissed from this action.
14 “ The term ‘material’ does not exist explicitly in the text of Section 10(b) . . . . However, the Supreme Courttreats Section 1 0(b) identically to Rule 10b-5 for purposes of materiality.” Greenhouse v. MCG Capital Corp., 392 F.3d650, 656 n.6 (4th Cir. 2004) (citing Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988)).
15 Although Lead Plaintiffs show more drastic percentage changes between the restatement and some of RedHat’s Forms 10-Q, Lead Pls.’ Br. Opp. at 12, as noted above, the court concludes that PwC cannot be held liable for anymisstatements in the quarterly reports, and thus will not consider these changes in determining whether PwC made amaterial misstatement of fact.
16 Although the Form K/A is not attached to the amended complaint, Lead Plaintiffs refer to it frequentlythroughout the complaint, and therefore it is appropriate for the court to consider it. See Greenhouse, 392 F.3d at 656-57(“a court ruling on a 12(b)(6) motion may look to documents or articles cited in the complaint, SEC filings, pressreleases, stock price tables, and other material on which the plaintiff’s allegations necessarily rely” (quotation andcitations omitted)).
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B. § 20(a) Claim
Section 20(a) of the Exchange Act provides:
Every person who directly or indirectly, controls any person liable under anyprovision of this chapter or of any rule or regulation thereunder shall also be liablejointly and severally with and to the same extent as such controlled person to anyperson to whom such controlled person is liable unless the controlling person actedin good faith and did not directly or indirectly induce the act or acts constituting theviolation or cause of action.
15 U.S.C. § 78t(a). “The language of § 20(a) assigns secondary liability only upon a demonstration
of a primary violation by the controlled person and of direct or indirect control by the controlling
person. Thus, a plaintiff’s failure to state a proper claim for a primary securities fraud violation
precludes a finding of control person liability.” In re E. Spire Commc’ns, Inc. Sec. Litig., 127 F.
Supp. 2d 734, 750 (D. Md. 2001) (citation omitted).
This claim was filed against individual defendants Szulik, Thompson, Webbink, Buckley,
and Cormier. Am. Compl. Count II. The only argument offered by defendants in support of
dismissing this claim is that Lead “[P]laintiffs have not alleged a predicate violation of the securities
laws by the Defendants,” and therefore the court should dismiss this claim. Red Hat Br. at 28.
Because the court has concluded that Lead Plaintiffs have alleged claims against defendants Szulik
and Thompson, the court will not dismiss this claim as to those defendants. Because the court has
concluded that Lead Plaintiffs have not alleged claims against defendants Webbink, Buckley, and
Cormier, the court will dismiss this claim as to those defendants.
C. Sarbanes-Oxley Act Claim
Lead Plaintiffs have asserted this claim only as to defendants Szulik and Thompson. Am
Compl. Count III. Section 304 of the Sarbanes-Oxley Act of 2002 provides for the forfeiture of
bonuses and profits by certain corporate officers if the corporation “is required to prepare an
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accounting restatement due to the material noncompliance of the issuer, as a result of misconduct,
with any financial reporting requirement under the securities laws[.]” 15 U.S.C. § 7243. Certain
provisions of the Sarbanes-Oxley Act include an express private right of action; Red Hat defendants
argue, and Lead Plaintiffs concede, that Section 304 does not. Red Hat Mem. at 29; Lead Pls.’
Mem. Opp. at 52. However, Lead Plaintiffs argue that under Cort v. Ash, 422 U.S. 66, 78 (1975),
the Supreme Court’s four-part test to determine “whether a private remedy is implicit in a statute
not expressly providing one[,]” Section 304 does create a private cause of action. Lead Pls.’ Mem.
Opp. at 54.
The first court to examine this issue, the Eastern District of Pennsylvania, analyzed Section
304 under the Cort factors and found “that Congress did not intend to create an implied cause of
action in Section 304 . . . .” Neer v. Pelino, 389 F. Supp. 2d 648, 657 (E.D. Pa. 2005). Two other
district courts have since been presented with the issue and followed the holding and reasoning of
Neer. See In re Whitehall Jewellers, Inc. S’holder Derivative Litig., No. 05 C 1050, 2006 WL
468012, *7 (N.D. Ill. Feb. 27, 2006) (unpublished) (“For the reasons explained here, this court, too,
agrees with Neer.”); In re BISYS Group Inc. Derivative Action, 396 F. Supp. 2d 463, 464 (S.D.N.Y.
2005) (Section 304 “does not expressly create a private cause of action in favor of the issuer or, for
that matter, anyone else. As plaintiffs concede, there is nothing in the legislative history to suggest
an intention to create a private right of action. In fact, the legislative history suggests strongly that
Congress intended that Section 304 be enforced only by the Securities and Exchange Commission.”
(citing Neer)). See also In re Cree, Inc. Sec. Litig., No. 1:03CV00549, 2005 WL 1847004 at *15
(M.D.N.C. Aug. 2, 2005) (“Although the court is doubtful of the existence of a private right to sue
under Section 304, it need not resolve the issue now”); In re Friedman’s, Inc. Derivative Litig., 386
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F. Supp. 2d 1355, 1368 n.20 (N.D. Ga. 2005) (“this Court ‘is doubtful of the existence of a private
right to sue under Section 304 . . . .’”(quoting and citing Cree, 2005 WL 1847004 at * 15)). Another
district court found that an investor-plaintiff could not bring suit under the section because the
investor was “not entitled to the reimbursement required by the statute, and . . . [was] not asserting
derivative claims on behalf of” the corporation. In re Qwest Commc’ns Int’l, Inc. Sec. Litig., 387
F. Supp. 2d 1130, 1150 (D. Colo. 2005). This court agrees with the analysis in Neer and finds that
Section 304 of the Sarbanes-Oxley Act of 2002 does not create a private cause of action.
In the alternative, Lead Plaintiffs contend that “even if this Court does not allow [Lead]
Plaintiffs to bring a cause of action under Section 304, . . . the Court should still allow [Lead]
Plaintiffs to plead Section 304 as a remedy of disgorgement [under principles of equity] instead of
a claim.” Lead Pls.’ Mem. Opp. at 54 (italics in original).
A claim for equitable relief shall not be maintained in the courts of the United Statesin any case where a plain, adequate and complete remedy is available at law.Matthews v. Rodgers, 284 U.S. 521, 525 . . . (1932); Potwora v. Dillon, 386 F.2d 74,77 (2d Cir. 1967). [Lead Plaintiffs] cite[] no law that supports [their] claim forequitable relief. Further, the court can find no basis for concluding that the remediesavailable in law are inadequate to provide relief. Therefore, [Lead Plaintiffs] ha[ve]failed to meet [their] burden for bringing a claim of equitable relief in federal court.
Pouliot v. Paul Arpin Van Lines, Inc., 303 F. Supp. 2d 135, 140 (D. Conn. 2004) (dismissing claim
for equitable indemnification under Fed. R. Civ. P. 12(b)(6)). In the absence of any case law
allowing such a claim and of any showing by Lead Plaintiffs why their other claims fail to
adequately provide them with relief, the court declines to allow Lead Plaintiffs to pursue this claim.
III. CONCLUSION
For the foregoing reasons, the motion to dismiss by PwC is ALLOWED, and it is
DISMISSED from this action. The motion to dismiss by Red Hat and the individual Red Hat
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defendants is ALLOWED IN PART, and defendants Webbink, Buckley, and Cormier are
DISMISSED from this action. Additionally, Count III of the Amended Complaint is DISMISSED.
This 12 May 2006.
W. Earl BrittSenior U.S. District Judge
rhi/tec
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