Institutional Investors Group v. Avaya, Inc.

• Citation: 564 F.3d 242
• Decision Date: 30 April 2009
• Docket Number: No. 06-4595.,06-4595.
• Parties: INSTITUTIONAL INVESTORS GROUP, Lead Plaintiff; Howard Charatz, individually and on behalf of all others similarly situated, Appellants v. AVAYA, INC.; Donald K. Peterson; Garry K. McGuire, Sr.
• Court: United States Courts of Appeals. United States Court of Appeals (3rd Circuit)

564 F.3d 242

INSTITUTIONAL INVESTORS GROUP, Lead Plaintiff;

Howard Charatz, individually and on behalf of all others similarly situated, Appellants v. AVAYA, INC.; Donald K. Peterson; Garry K. McGuire, Sr.

No. 06-4595.

United States Court of Appeals, Third Circuit.

Argued March 3, 2008.

Filed: April 30, 2009.

Sanford Svetcov, Esquire, (Argued), Coughlin Stoia Geller Rudman & Robbins, San Francisco, CA, for Appellants.

Steven M. Schatz, Esquire, (Argued), Wilson Sonsini Goodrich & Rosati Palo Alto, CA, Kerri E. Chewning, Esquire, Archer & Greiner Haddonfield, NJ, for Appellees.

Before: SCIRICA, Chief Judge, FISHER and ROTH, Circuit Judges.

OPINION OF THE COURT

SCIRICA, Chief Judge.

This is a shareholders securities action, putatively a class action, alleging defendants made false or misleading statements about earnings growth potential and pricing pressure in violation of the Securities and Exchange Act of 1934. Shareholders' central theory is that investors and analysts viewed the key to Avaya's success to be its ability to increase sales revenues without cutting prices. The District Court granted defendants' motion to dismiss for failure to meet the pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). We will affirm in part and reverse in part and remand for proceedings consistent with this opinion.

I.

Defendant Avaya Inc. sells communications products and services.¹ Shareholders allege Avaya, through its Chairman and CEO, defendant Peterson, and its CFO, defendant McGuire, (1) affirmatively denied unusual price competition was occurring during the class period, despite knowing there was price competition that was hurting profit margins; and (2) issued baseless financial projections and positive portrayals to the market despite knowing the projections and portrayals were impossible to fulfill in light of intense price competition and problems with the company's "go-to-market" (GTM) strategy.² Shareholders support their claims through a variety of circumstantial allegations of falsity and knowledge, including the accounts of confidential witnesses (CWs), analyst reports, and alleged "admissions" by Peterson and McGuire.

Statements during three separate portions of the class period form the basis of Shareholders' claims: (1) in late October 2004, after the start of Avaya's 2005 fiscal year (FY2005), Avaya, through Peterson and McGuire, announced results for FY2004 and made projections for FY2005; (2) in late January 2005, Avaya announced results for the first quarter of FY2005 and made positive portrayals; (3) in the first two weeks of March 2005, McGuire allegedly increased his revenue projections for FY2005 and made false or misleading comments about the state of Avaya's business. All of the statements fall into one of two general categories. First, there are "pricing-pressure statements," in which McGuire and Peterson are alleged to have falsely denied Avaya was offering unusual discounts and facing significant pricing pressure from market rivals. Second, there are "forecast-related statements," in which defendants projected financial results (such as operating margin and revenue growth) and made positive portrayals, notably the statement that Avaya was "on track" to achieve its goals or projections.

The Complaint alleges the following facts.³

A.

On October 26, 2004, Avaya released financial results for FY2004 and the fourth quarter of 2004 (Q4 FY2004), which had ended September 30, 2004. A press release stated in part: "We have entered the new year well positioned to translate our ongoing success in the marketplace into enhanced shareholder value." In a conference call for analysts and investors, Peterson elaborated: "Clearly we are enjoying significant momentum in the marketplace, and we are converting that momentum into increased profitability and financial strength. Underlying this momentum are our Company's strategic advantages." Peterson added that "[t]he end result is that today we are a stronger more competitive organization that enjoyed [sic] significant potential ... to further build shareholder value." When asked about prospects for operating margins, McGuire said he expected continued improvement in FY2005. Peterson commented on pricing: "I'd say pricing as a general comment is not different than what it has been. There continues to be ... pressure in the market, it's a very competitive marketplace but I wouldn't say there's anything particularly noteworthy in the trend line one way or the other."⁴

On October 29, Avaya issued a set of financial projections. For FY2005, the company projected an operating margin⁵ of 8.5% to 9% and revenue growth of 25% to 27%. For FY2006, it projected an operating margin of 10% to 12%. McGuire and Peterson spoke at a conference and made positive portrayals, focusing particularly on the 8.5% to 9% estimate for operating margin.

On January 25, 2005, defendants announced Avaya's financial and operational results for Q1 FY2005. The results were "in line with, or better than, analysts' expectations." First quarter operating income grew 70% year-over-year and the gross margin percentage⁶ was 47.3%. Total revenues grew 18% compared with Q1 FY2004.⁷ Notably, defendants stated: "Our first quarter results position us to meet our goals for the year"; and "we are on track to meet our goals for the year, even though there were some aspects of our performance that are below our expectations and that we are working on to improve."⁸

During a conference call with analysts, Peterson reiterated Avaya's FY2005 expectations:

Growing revenue 25 to 27 percent. Increasing operating income by 40 percent. Increasing our annualized margin to the 8.5 to 9 percent range, which would put us on the trajectory to go beyond that in 2006. All those things are on track. We do have a business that is somewhat more seasonal in its pattern than some of our data industry brethren, and this is a fall-over or holdover of the telecom business even though these things are merging in IP telephony. But we think that we had a solid quarter that is positioning us well to go on through the rest of the year and achieve those goals.

We will obviously report to you as we make that progress at the very least in our quarterly results. And if there is something particularly important, we will come to you before that, but otherwise assume that we are on track and going to make that — going to deliver on those promises as the year goes on.

On March 2, 2005, McGuire adjusted Avaya's projected annual revenue growth to 28%⁹ and noted that "we are building on the momentum that we've got in the market relative to the technology lead, our applications, ... and our global services." In response to analyst inquiries about the effect of pricing pressure from Cisco, McGuire stated that Cisco is "a good competitor ... to have relative to the pricing environment.... [I]f they start a price war in IP telephony, they're only going to further exacerbate the pressure they've got on gross margins. So in that regard, I kind of view them as a nice competitor to have because that's a problem they've got to live with." Similarly, on several occasions in March, McGuire said there were no significant changes to the pricing environment. See Statement of Garry McGuire, CFO, Avaya, Fourth Annual JMP Securities Research Conference (Mar. 2, 2005) ("Pricing environment is not significantly different. I mean, there are people that will buy a deal from time to time, but in general, the pricing environment is — has been fairly stable."); Statement of Garry McGuire, CFO, Avaya, Morgan Stanley Semiconductor and Systems Conference (Mar. 7, 2005) ("[C]learly from time to time people will want to buy a deal here or there, but the market itself has been fairly stable with just modest declines over the last 12 months."); Statement of Garry McGuire, CFO, Avaya, Deutsche Bank Securities Inc. IT Hardware Conference (Mar. 10, 2005) ("Pricing has been fairly steady for the last couple of years.... I don't see any reason that that would change significantly. I think that in the last year or so, it has really been a 2-horse race with us and Cisco in the IP telephony area.").

Also in March, analyst reports identified potential obstacles faced by Avaya. On March 4, 2005, members of the Buckingham Research Group performed a sales channel check and concluded that Avaya was experiencing "weak" spending for its products and had fired sales staff in order to cut costs. The analysts predicted Avaya's actions would "negatively effect [sic] growth." In addition, a March 21, 2005, Equity Research Update by Lehman Brothers analysts reported that Avaya resellers had indicated that the company was "offering aggressive [30-40%] discounts for its mid-range products (150-400 lines) since [the] beg[inning] of March [2005]."¹⁰ Lehman Brothers characterized the discounts as "quite unusual" and warned that if the promotion were highly successful, "Avaya's product margins would be somewhat impacted."

On April 19, 2005,¹¹ Avaya announced that it would be unable to meet its previously stated goals for growing revenues, operating income, and operating margin in FY2005. Avaya's Q2 FY2005 revenues increased 21% compared to the revenue in Q2 FY2004. The revenue growth "reflected the impact of Avaya's recent acquisitions and revenue growth internationally." But "U.S. product and services revenues declined year-over-year." On April 20, 2005, Avaya's stock price dropped approximately 25% — from $10.69 to $8.01.¹²

Peterson blamed internal problems, especially the GTM strategy, for the missed benchmarks. See Statement of Don Peterson, Chairman and CEO, Avaya, Q2 2005 Avaya Earnings Conference Call (Apr. 19, 2005) ("[W]ell over a majority of this shortfall I would attribute more to issues related to us than issues related to the market.... I think most of this [sic] are things that if I have to get to and fix and therefore they're within...