In re Sonus Networks, Inc.

Decision Date16 August 2007
Docket NumberNo. 06-1937.,06-1937.
PartiesIn re SONUS NETWORKS, INC, Shareholder Derivative Litigation. Michael Pisnoy; Michelle Burke, Derivatively on behalf of Sonus Networks, Inc., a Delaware Corporation; Daniel Williams, Plaintiffs-Appellants, v. Hassan M. Ahmed; Stephen J. Nill; Edward T. Anderson; Paul J. Ferri; Paul J. Severino; Sonus Networks, Inc.; Albert A. Notini; J. Michael O'Hara; Edward N. Harris; Paul R. Jones; Rubin Gruber, Defendants-Appellees.
CourtU.S. Court of Appeals — First Circuit

Willem F. Jonckheer, with whom Robert C. Schubert, Juden Justice Reed, Schubert & Reed LLP, Douglas M. Brooks, John Martland, and Gilman and Pastor, LLP, were on brief for appellants.

Daniel W. Halston, with whom Jeffrey B. Rudman, Peter A. Spaeth, Melissa B. Coffey, Wilmer Cutler Pickering Hale And Dorr LLP, Thomas J. Dougherty, Matthew J. Matule, Skadden, Arps, Slate, Meagher & Flom LLP, Robert S. Frank, Jr., John R. Baraniak, Jr., Choate Hall & Stewart LLP, and John D. Hughes, Edwards Angell Palmer & Dodge LLP, were on brief for appellees.

Before TORRUELLA, Circuit Judge, JOHN R. GIBSON, Senior Circuit Judge* and LIPEZ, Circuit Judge.

JOHN R. GIBSON, Circuit Judge.

Michael Pisnoy, Michelle Burke, and Daniel Williams, suing derivatively on behalf of Sonus Networks, Inc., appeal from the district court's order dismissing their suit on the basis of issue preclusion. In re Sonus Networks, Inc., S'holder Derivative Litig., 422 F.Supp.2d 281 (D.Mass.2006). They contend that the dismissal of an earlier derivative suit in Massachusetts state court for failure to plead either demand on the Sonus board of directors or the futility of such a demand should not bar this suit because the federal plaintiffs are not in privity with the state plaintiffs, the issue litigated in the state action was not identical to the issue presented here, and the state court dismissal was not "on the merits." We affirm.

I.

Sonus Networks, Inc., is a Delaware corporation headquartered in Massachusetts, which is in the business of providing equipment and software that permits speech to be transmitted in "packets" over the internet. On January 20, 2004, Sonus announced that it would postpone announcing its fourth quarter 2003 and 2003 fiscal year financial results pending completion of the 2003 audit. On February 11, 2004, Sonus announced that it had discovered that actions of certain non-executive employees might have improperly affected the timing of revenue recognition and thus could put into question the accuracy of Sonus's financial statements for 2003 and possibly earlier periods. The announcement stated that Sonus had responded to the discovery by terminating the employees implicated, launching an internal review as well as an investigation by the audit committee of the board of directors, and notifying the Securities Exchange Commission.

Within days of the announcement, shareholders had filed derivative lawsuits against officers and directors1 of Sonus in Massachusetts state court (February 20, 2004), while different shareholders filed similar suits in the federal court2 for the District of Massachusetts, where suits filed February 23, February 26, and March 24 2004, were consolidated. 422 F.Supp.2d at 285.

The state court complaint alleged that the defendants were guilty of breach of fiduciary duties to the corporation. According to the state complaint, as of January 20, 2004, Sonus's stock had increased by 800% in a year and was trading at $9.91 per share, fueled by optimistic press releases from Sonus regarding its future profitability. The complaint alleged that after the announcement on February 11, 2004, Sonus had "identified certain issues, practices and actions of certain employees" that could affect the accuracy of its 2003 financials and possibly the financials from earlier periods, the company's stock fell by 46%. The state complaint said that the financials had "materially overstate[d]" earnings and that the 2003 financials would have to be restated "to remove millions in improperly reported revenues." The complaint quoted a news article that implied there was reason to think there had been a leak of information the day of the announcement because Sonus's stock began falling at 11:00 a.m. on February 11, although the bad news was not announced until the close of business. The state complaint listed officers and one director who had sold Sonus stock at different points in 2003, including director Anderson's sale of $448,918.34 worth of stock on October 18, 2003, but the complaint made no particular allegation that anyone traded before the announcement on February 11, 2004. The complaint alleged that Sonus was injured by the loss in value resulting from public distrust of the company's financial reports, exposure to liability and litigation costs in fraud lawsuits, and the costs of investigation.

The state plaintiffs pled that they had not made demand on Sonus's board of directors to file suit on behalf of the corporation before the plaintiffs filed their derivative suit because such a demand would have been futile in light of the fact that the complaint named all of the six directors as defendants and so the directors would have had to sue themselves.3 The plaintiffs also alleged that each of the directors had participated in wrongdoing because each "knew" of the accounting problems, and Anderson sold stock while he knew of the problems but before Sonus had announced them publicly. Moreover, the directors were alleged to lack independence from each other by virtue of the facts that two of them (Ahmed and Gruber) worked for Sonus as their principal occupation and two of them (Ferri and Severino) were on the compensation committee. Further, three of the defendants (Anderson, Ferri, and Severino) served on the audit committee and so were alleged to be financially interested in avoiding liability for their failures of oversight. Four of the six directors sued were "outside" directors.

Notably absent from the complaint was any indication of what the final results of the internal, audit committee or SEC investigations were, what the effect of the alleged irregularities would be on financial statements for any year, and whether there had been any judicial or administrative finding of wrongdoing by any of the defendants — absences which are not surprising, considering the complaint was filed within nine days of Sonus's February 11, 2004, announcement, apparently on the theory that the race is to the swift.

The state court dismissed the state suits on September 27, 2004, for failure to comply with Mass. R. Civ. P. 23.1, which requires a shareholder in a derivative action to "allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors or comparable authority and . . . the reasons for his failure to obtain the action or for not making the effort." In re Sonus Networks, Inc. Derivative Litig., No. 04-0753 BLS, 2004 WL 5316105 (Mass.Super.Ct. Sept. 27, 2004). The state court held that the complaint before it did not allege a specific wrongful act by the defendants, but rather a failure of supervision over the financial statements. The court held that the state plaintiffs had not pleaded facts that would raise a reasonable doubt that a majority of the directors had a financial interest that would prevent them from fairly considering a demand or that they lacked the independence necessary to consider such a demand. The court dismissed the complaint without leave to amend. The state plaintiffs appealed, but later withdrew their appeal "[in] light of the Securities and Exchange Commission's action as reported in Sonus's Form 8-K, dated June 9, 2005," as they said in their motion to withdraw the appeal.

In the meanwhile, the plaintiffs in the consolidated federal cases filed a Second Amended Consolidated Complaint of some seventy pages on July 1, 2005. The Second Amended Complaint included substantially all the allegations made in the state complaint, plus some allegations regarding events that had taken place before the state suit was filed or while it was pending, but which had not been included in the state complaint, and some allegations regarding events that occurred after the state suit was dismissed.

The events antedating the filing of the suits were statements in Sonus's SEC filings in 2001 and 2002 reporting in the same language for both years that the company's growth was placing a "significant strain" on the Company's systems and that the company would need to "continue to improve our financial, managerial and manufacturing controls and reporting systems." Additionally, the plaintiffs alleged that Sonus had been sued on March 3, 2003, in securities class action complaints alleging the company's financial statements were overstated in 2001. Notably, the Second Amended Complaint did not allege that the plaintiffs in the securities case had prevailed.

Events alleged to have occurred during the pendency of the state suits were:

(1) On March 29, 2004, Sonus announced it was considering expanding the previously announced internal investigation to include additional prior periods, and

(2) On July 28, 2004, Sonus restated its financial results for 2001, 2002, and the first three quarters of 2003. The effect of the restatements was to reduce the net loss reported in 2001 from $645.4 million to $635.6 million and to increase the net losses reported in 2002 and the first three quarters of 2003 from $68.5 million and $6.4 million, respectively, to $73.8 million and $22 million. Sonus also announced on that date that Stephen J. Nill, formerly Sonus's chief financial officer, had resigned at the request of the company. On the same day, Sonus filed a Form 10-K/A that disclosed that Sonus's internal investigation had "identified material weaknesses in our internal controls and procedures, as they existed as of December 31, 2003...

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