In re Engineering Animation Securities Litigation, 4-99-CV-10117.

Citation110 F.Supp.2d 1183
Decision Date24 March 2000
Docket NumberNo. 4-99-CV-10117.,4-99-CV-10117.
PartiesIn re ENGINEERING ANIMATION SECURITIES LITIGATION
CourtUnited States District Courts. 8th Circuit. United States State District Court of Southern District of Iowa

David L Phipps, Whitfield & Eddy PLC, Des Moines, IA, Steven G Schulman, Samuel H Rudman, David J Bershad, Janine L Pollack, Milberg Weiss Bershad Hynes & Lerach Llp, New York, NY, Jeffrey R Anderson, Randall H Steinmeyer, Reinhardt & Anderson, St Paul, MN, Jack G Fruchter, Fruchter & Twersky, New York, NY, for Abraham Schreiber.

David L Phipps, Terri L Combs, Faegre & Benson, Des Moines, IA, Boris Feldman, Wilson Sonsini Goodrich & Rosati, Palo Alto, CA, Andrew L Barroway, Schiffrin & Craig Ltd, Bala Cynwyd, PA, Steven G Schulman, David J Bershad, Janine L Pollack, Milberg Weiss Bershad Hynes & Lerach LLP, New York, NY, Jeffrey R Anderson, Reinhardt & Anderson, St. Paul, MN, Jack G Fruchter, Fruchter & Twersky, New York, NY, for Daniel Sepe.

David L Phipps, Whitfield & Eddy, PLC, Des Moines, IA, David J Bershad, Janine L Pollack, Milberg Weiss Bershad Hynes & Lerach, LLP, New York, NY, Jack G Fruchter, Fruchter & Twersky, New York, NY, for David Hershkowitz, Madelon R. Tyler.

David L Phipps, Whitfield & Eddy, PLC, Des Moines, IA, Steven G. Schulman, David J Bershad, Janine L Pollack, Milberg Weiss Bershad Hynes & Lerach, LLP, New York, NY, Jeffrey R. Anderson, Reinhardt & Anderson, St. Paul, MN, Jack G Fruchter, Fruchter & Twersky, New York, NY, David R Scott, Scott & Scott LLC, Colchester, CT, Steven E Cauley, Law Offices of Steven E Cauley PA, Little Rock, AR, for Rocco Spaccio.

Terri L Combs, Faegre & Benson, Des Moines, IA, Boris Feldman, Lyle Roberts, Christian Word, Wilson Sonsini Goodrich & Rosati, Palo Alto, CA, for Matthew M. Rizai.

Boris Feldman, Lyle Roberts, Christian Word, Wilson Sonsini Goodrich & Rosati, Palo Alto, CA, for Martin J. Vanderploeg, Jerome M Behar, Jamie A Wade, Engineering Animation, Inc.

ORDER

LONGSTAFF, District Judge.

Before the Court is a motion to dismiss brought by defendants Engineering Animation, Inc. ("EAI"), Matthew M. Rizai, Martin J. Vanderploeg, Jerome M. Behar and Jamie Wade (collectively, "defendants"). The motion was filed on October 13, 1999. Plaintiffs, a class representing shareholders of EAI, filed a memorandum of law opposing defendants' motion to dismiss on December 7, 1999. Defendants filed a reply brief on January 31, 2000. The matter is now considered fully submitted.1

I. BACKGROUND

EAI is a Delaware corporation which is located in Ames, Iowa.2 It was incorporated in 1989. EAI specializes in developing and applying two and three dimensional visualization technology. EAI develops and produces software for manufacturing companies and for use in the education, consumer and entertainment markets. Its stock is traded on the Nasdaq National Market.

Defendant Matthew M. Rizai serves as EAI's chairman, chief executive officer, director and treasurer. Martin J. Vanderploeg is a director and executive vice president for EAI. Jerome M. Behar has served as EAI's vice president of finance and chief financial officer since August 1997. Jamie Wade is vice president of administration and general counsel for EAI.

This action is brought by a class of plaintiffs who purchased the common stock of EAI between February 19, 1998 and April 6, 1999 ("the relevant class period"). The lead plaintiffs are Ronald Buch, Richard Dunphy, Vladimer Katz, Gilbert F. Mueller, Jr. and L.D. Eisenhart. Plaintiffs claim defendants conducted a continuous fraudulent scheme which injured all purchasers of EAI common stock during the relevant class period. The plaintiffs bring these claims based on alleged violations of Section 10(b) and 20(a) of the Securities and Exchange Act of 1934(SEA), along with Rule 10b-5 promulgated thereunder. Particularly relevant to these claims, and this motion by the defendants, is The Private Securities Litigation Reform Act of 1995 ("PSLRA"), Pub.L. No. 104-67.3

The continuous fraudulent scheme alleged by the plaintiffs will be divided into three categories of activities by the defendants for the purposes of this Order. First, plaintiffs allege defendants violated SEA sections 10(b), 20(a) and Rule 10b-5 via their accounting practices. The accounting practices at issue center around the acquisition of two other companies by EAI, and how those companies were recorded on EAI's books. Second, plaintiffs allege in their complaint that as a part of defendants' fraudulent scheme, defendants concealed their problems in product development and finalizing contracts in the winter and spring of 1999. Plaintiffs allege that these activities by defendants occurred primarily in February and March 1999, and constitute omitted material facts. Third, plaintiffs allege defendants violated the relevant statutory sections and rule with disclosures, filings and statements associated with the acquisition of two other companies and the product development problems. Plaintiffs allege these activities constituted fraudulent statements by the defendants.

Accounting Practices

In November 1997, EAI acquired a company entitled Rosetta. EAI paid for this acquisition in two separate transactions by exchanging shares of its own outstanding common stock for shares of Rosetta common stock. In the second transaction to acquire Rosetta, EAI acquired approximately $7.1 million worth of Rosetta common stock, or 32% of the total value of Rosetta common stock. Of this amount, EAI allocated $5.6 million dollars to inprocess research and development ("IPR & D").

On June 17, 1998 EAI acquired a second company which was entitled Sense8. This acquisition cost EAI $7.0 million of its own stock. Sense8 was a company in financial distress, as its liabilities exceeded its assets by approximately $2.4 million. Therefore, the total acquisition cost for EAI was $9.4 million. EAI recorded this acquisition as a purchase of $500,000 of goodwill and $9.8 million of IPR & D Plaintiffs argue that by allocating significant portions of the purchase price of both Rosetta and Sense8 to IPR & D, EAI was able to boost its future earnings. Further, plaintiffs argue this was improper as contemplated by the standards set by generally accepted accounting principles ("GAAP"). Plaintiffs argue that both Rosetta and Sense8 had products that were already in use, and therefore the moneys that were expensed and written off as IPR & D should have been capitalized and recorded as assets. See Compl. ¶¶ 73-79.4 Rosetta had software products which had already been licensed to customers, called PreVIEW and Prepare software products. Sense8 products were also already in existence, and EAI hoped to integrate their products with EAI's own VisProducts. Plaintiffs argue defendants' motives in allocating so much of the acquisitions to IPR & D was to inflate the price of the stock so that they could sell their own shares at an inflated price.

Product Development and Contract Finalization

Defendant experienced product development and contract signing problems in connection with its new VisView product, an outgrowth of its merger with Rosetta.5 Specifically, the product's release was delayed, and under pressure to get the product on the market, EAI cut short its quality assurance department's opportunity to fully test the product. When it was put on the market in March of 1999, customer dissatisfaction followed and major customers such as Lockheed Martin and Raytheon expressed their displeasure and refused to sign new contracts with EAI. Plaintiffs argue this information was clear to defendants in late February, or in the first week of March 1999, and at this time a company-wide teleconference was held detailing the contract problems, which were apparent. However, EAI did not inform the public at that time that the company would not meet its 1999 first quarter earnings estimates.

Filings, Releases, and Statements by Defendants

On March 4, 1999 EAI filed with the SEC amended 1997 10-K forms, and amended 10-Q forms for the first three quarters of 1998. These amended filings followed a statement by EAI representative Behar on February 18, 1999 in a press release that the company's IPR & D calculations in connection with Rosetta and Sense8 acquisitions would be amended, and that these amendments would "ha[ve] no impact on the Company's cash flows for any prior or future period." Ultimately, in the amendments EAI changed its original allocation of $5,599,000 to IPR & D from the Rosetta acquisition to $1,684,000, a 70% reduction; and also the IPR & D allocation for the acquisition of Sense8 changed from $9,800,000 to $1,900,000, an 81% reduction. The stock price did not drop immediately following the accounting change or the announcement of it.

As further evidence of an alleged fraudulent scheme by the defendants, plaintiffs specify press and financial information releases made by EAI during the relevant class period. These releases contained statements which relied upon the original IPR & D calculations from the two acquisitions.6 The plaintiffs list a number of press releases and financial filings where EAI used the original IPR & D calculations, which showed higher revenues and less loss than would have been shown had the corrected IPR & D figures been used. Plaintiffs argue these were false statements by the company, a part of the continuous scheme by defendants to defraud.

On March 26, 1999 the Dow Jones Business News quoted defendant Rizai as saying it would be a "fair assumption" that EAI would meet its first quarter projections.7 But, EAI did not meet its first quarter projections for 1999. On April 6, 1999 the failure became public as EAI revenues were announced in a press release at 15% below analyst's estimates. EAI appears to have attributed this shortcoming to the company's failure "to close six contracts" and defendant Rizai stated, "I'm more than disappointed — I'm personally embarrassed." The following day, April 7, EAI suffered...

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