In re Smartalk Teleservices Securities Litigation, No. 00-1315.

• Decision Date: 01 November 2000
• Docket Number: No. 00-1315.
• Citation: 124 F.Supp.2d 527
• Parties: In re SMARTALK TELESERVICES, INC. SECURITIES LITIGATION, This Document Relates To: All Actions Particularly USDC S.D. Ohio Case No. C2-98-814
• Court: U.S. District Court — Southern District of Ohio

124 F.Supp.2d 527

In re SMARTALK TELESERVICES, INC. SECURITIES LITIGATION,

This Document Relates To: All Actions Particularly USDC S.D. Ohio Case No. C2-98-814

No. 00-1315.

United States District Court, S.D. Ohio, Eastern Division.

November 1, 2000.

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Greg May, Munsch Hardt Kopf Harr & Dinan, Dallas, TX, Evans L. Land, Ann E. Bennington, Sidney Williams, Hahn Loeser & Parks, Columbus, OH, Darryl Paul Rains, San Francisco, CA, for Smartalk Teleservices, Inc.

Richard Stuart Wayne, Strauss & Troy, Cincinnati, OH, Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, for Richard A. Eckstein.

Marilyn Ruth Donoff, M R Domoff and Associates, Dayton, OH, Maribeth Deavers, Lionel Z. Glancy, Lionel Z. Glancy Law Offices, Los Angeles, CA, for Allison Mizraji.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, William S. Lerach, Milberg Weiss Bershad Hynes & Lerach, San Diego, CA, Kevin P. Roddy, Milberg Weiss Bershad Hynes & Lerach, Los Angeles, CA, Stephen Richard Basser, Barrack Rodos & Bacine, San Diegao, CA, for Sidney Weinstein.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, Kurt B. Olsen, Kurt Olsen Law Offices, Washington, DC, for Charles R. Ostroff.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, Richard S. Schiffrin, Schiffrin Craig & Barroway, Bala Cynwyd, PA, for Gerald Tobin.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, Jeffrey H. Squire, Kaufman Malchman Kirby & Squire, New York City, for Patricia Bartolomeo.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, Stanley Grossman, Pomerantz Haudek Block & Crossman, New York City, for David Jaroslawicz.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, Robert N. Kaplan, Kaplan Kilsheimer & Fox, New York City, for David Turf.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, Joel Sanford Taylor, Anthony J. Celebrezze, Jr., Dinsmore & Shohl, Columbus, OH, Kenneth A. Sweder, Sweder & Ross, Boston, MA, for Victor Grillo, Jr., Lloyd Lapidus, DTR Associates, Inc.

Maribeth Deavers, Martin Pergram & Browning, Worthington, OH, Daniel R. Karon, Robert N. Kaplan, Kaplan Kilsheimer & Fox, New York City, for Lisa Ernst.

Boris Feldman, Bredhoff & Kaiser, Washington, DC, Keith Eggleton, Wilson Sonsini Goodrich & Roseati, Palo Alto, CA Sidney Williams, Hahn Loeser & Parks, Columbus, OH, for Robert H. Lorsch.

Boris Feldman, Bredhoff & Kaiser, Washington, DC, Sidney Williams, Hahn Loeser & Parks, Columbus, OH, for Erich L. Spangenberg, Glen Andrew Folck, Richard Teich, David A. Hamberger.

Sidney Williams, Hahn Loeser & Parks, Columbus, OH, for Robert M. Smith, Fred F. Fielding, Ahmed O. Alfi, Wayne V. Wooddell.

Thomas Leslie Long, Baker & Hostetler, Columbus, OH, for Amre Younesss, Lisa Marino.

John Joseph Kulewicz, Vorys Sater Seymour & Pease, Columbus, OH, for Pricewaterhousecoopers LLP.

Joel Sanford Taylor, Dinsmore & Shohl, Columbus, OH, Kenneth A. Sweder, Sweder & Ross, Boston, MA, for Smartalk Partners.

OPINION AND ORDER # 2

SARGUS, District Judge.

This matter is before the Court on the Individual Defendants' Motion to Dismiss the Consolidated and Amended Class Action Complaint and on Defendants SmarTalk Partners, LLC Amre Youness and Lisa Marino's Motion to Dismiss the same Complaint ("Class Complaint"). For the Reasons that follow, the Court DENIES the Motions.

I. Background.

Plaintiffs acquired stock in SmarTalk Teleservices Inc. ("SmarTalk") between August 13, 1997 and January 7, 1999 inclusive ("the relevant time period"). SmarTalk later filed for bankruptcy. Plaintiffs filed suit alleging, inter alia, that SmarTalk officers and directors presented a false picture of SmarTalk through various public statements. According to the Plaintiffs, the Defendants falsely stated SmarTalk's revenues and profits in SEC filings, in press releases, and in conference calls with analysts and investors. The Defendants allegedly did this in order to inflate the value of SmarTalk stock so that SmarTalk could use its stock as consideration to acquire other companies and so that the individuals associated with the company could sell their personal holdings in SmarTalk stock at an inflated price. The Plaintiffs focus their claims on the fact that in August of 1998, SmarTalk announced that it its accountants had advised the company that there were some potentially significant accounting errors in the treatment of a number of acquisitions SmarTalk made in 1997. As a result of these and other errors, SmarTalk was forced to restate the company's 1997 financial statements, as well as quarterly statements for the first three quarters of 1998. These restatements caused the value of SmarTalk stock to drop significantly and SmarTalk eventually filed for bankruptcy. Plaintiffs raise claims under the Securities and Exchange Act of 1934 (the "Act") as modified by the Private Securities Litigation Reform Act of 1995 ("PSLRA").

A. SmarTalk.

SmarTalk was formed in 1994 to sell prepaid phone cards to the public through retailers and distributors. (Class Complaint ¶¶ 13, 35). SmarTalk grew rapidly, mostly through acquisitions, and became one of the largest providers of prepaid telecommunications products and services in North America. (Id. at ¶¶ 13, 36, 37).

Trouble hit on August 10, 1998 and on October 23, 1998 when SmarTalk announced that its financial statements for the third quarter 1997, through the second quarter 1998 contained material overstatements of revenue. Also, on January 7, 1999, SmarTalk announced that its third quarter 1998 financial statements were overstated.

The Company's revenues for 1997, reported as $32 million, were overstated by $8.3 million or 35%. In addition, net income from continuing operations over the same period, reported as $2.7 million, actually was a loss of over $7 million.

The same was true of the results reported for the first quarters of 1998. Cumulative revenues for those quarters, initially reported as over $151 million, was over-stated by $15.7 million or 12%; cumulative losses from continuing operations, initially reported as almost $23 million, were understated by over $45 million, or by 197%; and net losses for the same nine month period, initially reported as $23.7 million were understated by over $49 million or 207%.

According to the Class Complaint, these misstatements were the result of numerous fraudulently committed accounting errors. Specifically, Plaintiffs allege that SmarTalk fraudulently inflated SmarTalk's reported revenues and/or earnings by:

• improperly categorizing as ordinary "goodwill" at least $88.9 million of intangible assets purchased during four of SmarTalk's 1997 acquisitions so that the associated purchase price could be amortized over 15-20 years rather than 2-10 years, thereby reducing the amortization expenses and increasing earnings (Class Complaint at ¶¶ 47-52);

• taking "big bath" one-time charges totaling $64.2 million in connection with SmarTalk's December 1997 acquisition of ConQuest Telecommunications Services Corp. ("ConQuest") — equal to the entire purchase price — allowing defendants to inflate later period earnings by improperly transferring expenses incurred in these later periods back into the charge previously recorded as capital expenses rather than operating expenses, (Id. at ¶¶ 53-57);

• accounting for acquisitions in 1997 involving the issuance of SmarTalk shares by improperly using the share price on the day of the announcement rather than the three day average of the share prices spanning the announcement of the transaction resulting in a lower acquisition cost to SmarTalk — thereby reducing amortized goodwill expenses by $7 million, (Id. at ¶¶ 58-60);

• improperly reporting as capital expenses at least $10.9 million in marketing expenses paid to manufacturers and retailers to carry SmarTalk's product thereby spreading the expense associated with these items over a number of years rather than properly incurring these expenses in fiscal year 1997 and the first and second quarters of 1998, (Id. at ¶¶ 61-64);

• improperly recognizing the deferred revenues and breakage revenues of the companies SmarTalk acquired in 1997, (Id. at ¶¶ 65-70);

• failing to write off impaired or uncollectible accounts receivable, (Id. at ¶¶ 71-74);

• creating a sham sale of SmarTalk's money-losing call center operations at a price of $20 million to a related party that had no prior material operations or assets and thus lacking in any ability to pay, (Id. at ¶¶ 75-79).

According to the Class Complaint, SmarTalk's dissemination of false financial statements in 1997 and 1998 artificially inflated the market price of SmarTalk's stock. Stock prices increased from $18-7/8 per share at the beginning of the relevant time frame to as high as $36-1/2 per share. On February 26, 1998 for instance, after SmarTalk's fallacious announcement of "record revenues and earnings" for the quarter and year ending December 31, 1997, SmarTalk's stock surged 23% from $27-7/16 to $33-5/8 in a single day on extraordinarily high volume of 3.64 million shares — more than 7 times the three month daily average.

During the relevant time frame, the Defendants personally sold over 2.7 million shares of SmarTalk stock for over $63 million. For instance, on November 12, 1997, SmarTalk announced record results for the third quarter of 1997. On November 20, 1997, Defendant Lorsch sold 1.3 million shares of SmarTalk stock for $29.9 million. Similarly, on February 26, 1998, SmarTalk announced its fourth quarter 1997 results. Between March 2 and March 12, 1998, certain of the Defendants sold 261,480 shares for over $8 million.

In addition, during the relevant time frame, SmarTalk acquired at least two companies and raised $180 million in capital though a convertible notes offering and an equity offering. Those misstatements and corresponding sales of stock make up the heart of the...