Tuchman v. DSC Communications Corp.

Decision Date25 February 1994
Docket NumberNo. 93-1328,93-1328
Citation14 F.3d 1061
PartiesFed. Sec. L. Rep. P 98,096, 28 Fed.R.Serv.3d 159 Bruce H. TUCHMAN, On Behalf of Himself and All Others Similarly Situated, et al., Plaintiffs-Appellants, v. DSC COMMUNICATIONS CORPORATION, et al., Defendants-Appellees.
CourtU.S. Court of Appeals — Fifth Circuit

W.D. Masterson, III, Kilgore & Kilgore, Inc., Dallas, TX, Samuel P. Spore, Miles M. Tepper, Schoengold & Sporn, New York City, for plaintiffs-appellants.

E. Russell Nunnally, Sally Christine Helppie, Johnson & Gibbs, Dallas, TX, Michael J. Chepiga, Nancy Mallory, Peter J. Beshar, Simpson, Thacher & Bartlett, New York City, for defendants-appellees.

Appeal from the United States District Court for the Northern District of Texas.

Before GOLDBERG and JOLLY, Circuit Judges. *

GOLDBERG, Circuit Judge:

In this appeal, we must determine whether the district court properly dismissed the appellants' securities fraud claims against DSC Communications Corporation ("DSC") and several other individual defendants. The district court dismissed the appellants' claims without prejudice. 818 F.Supp. 971. The court first held that the appellants' federal securities fraud claims failed to state a claim upon which relief could be granted because the complaint did not adequately allege scienter. The court also concluded that the appellants failed to plead their federal securities fraud claims with sufficient particularity. Having dismissed the federal claims, the district court then denied a pending motion for class certification as moot and declined to exercise jurisdiction over the supplemental state law claims. After a careful review of the complaint, we affirm the judgment of the district court.

I. Facts and Proceedings Below

DSC is a publicly held corporation with approximately 41 million shares of stock outstanding. The company designs, manufactures, markets, and services advanced telecommunications switching systems and other products for domestic and international long distance telephone companies, local exchange carriers, and private network customers. One of DSC's principal products is the MegaHub Signal Transfer Point ("STP"). The MegaHub STP is an integral part of a high-capacity telephone call routing and switching system used by five of the seven regional Bell telephone companies: Bell Atlantic, Pacific Telesis, Ameritech, Southwestern Bell, and U.S. West.

In March of 1991, DSC shipped upgraded software for the MegaHub STP to its Bell customers. In April and May of that year, these companies installed the upgraded software. On June 10, 1991, Pacific Bell (a subsidiary of Pacific Telesis) experienced severe local telephone service disruptions in Los Angeles. On June 26, Pacific Bell and Bell Atlantic suffered extended telephone network system failures that shut down most local telephone service in Los Angeles, the District of Columbia, Maryland, Virginia, and West Virginia. On July 1 and 2, Bell Atlantic experienced a similar network failure in western Pennsylvania. On July 1, Pacific Bell's San Francisco-area signalling system began to shut down as well. In each instance, the afflicted companies were using their newly installed DSC software.

Within days, Congress decided to investigate the causes of these system failures. Frank Perpiglia, DSC's vice president of corporate planning, testified before the House Subcommittee on Telecommunications and Finance on July 9, 1991 and before the House Subcommittee on Government Information, Justice, and Agriculture on July 10, 1991. Perpiglia candidly acknowledged that DSC equipment had been a contributor to the telephone service outages. He also allowed that it had been a mistake to deliver to DSC's Bell customers the upgraded software for the MegaHub STP without putting it through the 13-week test that DSC typically performs before delivering new software products to its customers.

On July 11, 1991, only one day after Perpiglia completed his testimony before Congress, appellant Bruce Tuchman filed a class action securities fraud complaint against DSC and several individual defendants. 1 Tuchman sought to represent the class of all shareholders who purchased DSC stock between February 7, 1991--the date of DSC's 1990 Annual Report--and July 9, 1991. Several other strikingly similar complaints were filed within the next few days. These suits were consolidated with Tuchman's suit. A consolidated class action complaint was then filed, amending the appellants' previous complaints and extending the class period to October 30, 1991--the day before DSC announced its third quarter results for 1991. 2 The consolidated complaint alleged that the defendants violated Sec. 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. Sec. 240.10b-5. 3 This complaint also raised state common law fraud and negligent misrepresentation claims.

The consolidated complaint, despite its length, is not a model of specificity. Pleaded almost entirely on information and belief, it states that the defendants made "proud and optimistic portrayal[s] of DSC's current and projected business, marketing, technological and financial achievements" despite the fact that DSC was "badly lagging behind its competitors in terms of new product development, product quality, cost containment, and product sales." The plaintiffs charge that the defendants thus contrived a "scheme to foster the illusion that DSC was in the forefront of the industry in terms of product quality and innovation, had the ability to meet the demands of its customers in the rapidly changing technological environment, would continue to attract business, generate substantial revenues and positive earnings, would at least maintain, if not increase, gross profit margins, and would be able to attract sufficient financing to maintain and develop a competitive product line."

To carry out this alleged scheme, the plaintiffs claim that the defendants portrayed DSC to the public as "an industry leader in research and development, product innovation, manufacturing and marketing of sophisticated telecommunications switching equipment and systems of the highest quality, efficiency, and reliability, and as enjoying wide and growing customer acceptance of and satisfaction with its products." The plaintiffs also assert that the defendants depicted DSC "as being financially sound, having substantial assets (including inventory and receivables), and expecting long-term growth in its revenues, gross profit margins, earnings, and market share, while characterizing disappointing results and/or unfulfilled expectations in those areas as being merely temporary, and resulting primarily from general 'current economic conditions', 'economic uncertainties', and, more particularly, 'delays' in its customers' purchasing decisions."

The plaintiffs charge that these statements were materially false or misleading (or omitted to state material facts necessary to render them not false or misleading) because:

(a) DSC was experiencing increasing pressures from its competitors and its competitive position in the industry was rapidly declining, necessitating drastic price cuts and resulting in declining sales of its products, declining gross margins and losses;

(b) DSC had an unfavorable product mix and was severely lagging in innovation and product development in a complex industry in which rapid technological advancement and product innovation are essential to maintain profitability and growth;

(c) Customers were not delaying purchasing decisions, but were in fact cancelling orders for, returning DSC products and/or maintaining or even increasing their purchasing levels of comparable equipment--but from vendors other than DSC;

(d) DSC materially overstated assets, including inventory and receivables, and income. Material amounts of inventory represented cancelled orders, and returned, obsolete and/or defective products which were nevertheless carried on the Company's books and reported at inflated values. The massive write-downs of inventory and receivables for the 1991 third quarter should have been disclosed and reported in the Company's financial statements for prior periods;

(e) DSC's software, including its intelligent network system software, hardware, hardware components (including printed circuit boards), switches, and expansions, were insufficiently tested before being marketed, released and shipped to its customers and contained material manufacturing, design and operational defects, including defects known to the Company prior to shipment;

(f) DSC's software, including intelligent network systems software, could not be relied upon to perform the complex routing and other telecommunications tasks which customers (and the investment community) were told that it could perform;

(g) DSC sacrificed manufacturing quality and failed adequately to test its hardware equipment and software because of its overriding desire to "rush to market" with its products to get a jump on its competitors;

(h) The consequences of (e), (f) and (g), above, including massive telephone disruptions and outages, associated costs of the disruptions and outages, cancellations of orders by customers, returns of equipment, loss of business to DSC's competitors, and resultant revenue and income declines, were contingencies known to, foreseen by and/or recklessly disregarded by DSC and would place, and in fact did place, DSC in non-compliance with certain financial covenants under its senior loan agreements, including its bank revolving credit agreement and other senior borrowings, rendering it unable to make the interest payments due on its 7 3/4% convertible debentures, and causing a lowering of its debenture ratings by ratings agencies. This in turn accelerated customer defections to DSC's competitors because of concerns as to DSC's ability to obtain financing for its continued operations; and

(i) Such weaknesses as...

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