Stevelman v. Alias Research Inc.

• Decision Date: 05 April 1999
• Docket Number: No. 97-9544,97-9544
• Citation: 174 F.3d 79
• Parties: Paul STEVELMAN, individually and on behalf of all others similarly situated, Plaintiff-Appellant, v. ALIAS RESEARCH INC. and Stephen R.B. Bingham, Defendants-Appellees.
• Court: U.S. Court of Appeals — Second Circuit

Page 79

174 F.3d 79

Paul STEVELMAN, individually and on behalf of all others

similarly situated, Plaintiff-Appellant, v. ALIAS RESEARCH INC. and Stephen R.B. Bingham, Defendants-Appellees.

No. 97-9544.

United States Court of Appeals, Second Circuit.

Argued Jan. 27, 1999.

Decided April 5, 1999.

Jonathan M. Plasse, New York, N.Y. (James M. Strauss, Goodkind Labaton Rudoff & Sucha row LLP, New York, N.Y.; Gardner & Weiss, New York, N.Y., on the brief), for plaintiff-appellant.

David S. Godkin, Boston, Mass. (Carl E. Metzger, Inez H. Friedman, Testa, Hurwitz & Thibeault, Boston, Mass., on the brief), for defendants-appellees.

Before: NEWMAN, WALKER, and CALABRESI, Circuit Judges.

JON O. NEWMAN, Circuit Judge:

This appeal primarily requires consideration of the degree of particularity required for pleading fraud in a securities fraud action. Paul Stevelman appeals from the November 25, 1997, judgment of the United States District Court for the District of Connecticut (Ellen Bree Burns, District Judge) dismissing with prejudice his securities and common law fraud action against Alias Research Inc. and its former chief executive officer, Stephen R.B. Bingham. The District Court ruled that Stevelman's amended complaint was deficient under Rule 9(b) of the Federal Rules of Civil Procedure by failing to allege the circumstances of the claimed fraud with sufficient particularity.

Background

At the time of the conduct at issue, Alias Research Inc. ("Alias") was a publicly held Canadian corporation, engaged in computer software development. Its shares traded over-the-counter on NASDAQ. ¹ In June 1991, Alias had 5.5 million shares outstanding, of which Stephen R.B. Bingham, the chairman, CEO, president, and co-founder of Alias, owned 8.4%.

In late 1990 through 1991, Alias made a number of announcements indicating its acquisition of various other businesses and software lines. On April 3, 1991, Alias released its fiscal year-end results for 1990. In its press release, Alias claimed revenues of $22,801,000, a 90% increase over its 1989 revenues of $12,006,000. The company reported a net income of $.58 per share, compared to a 1989 net income of $.38 per share. Other statements by Bingham in this press release painted a rosy picture of Alias's short-term and long-term growth prospects. On April 16, 1991, Alias filed its Form 10-K and 1991 Annual Report with the SEC. Both documents cast Alias's recent acquisitions in a positive light. Alias wrote:

[T]he Company anticipates that its current cash requirements will be satisfied by cash flow from existing operations, existing cash and short term investments (including the net proceeds from the Company's initial public offering), and if needed, an arrangement with a bank pursuant to which the bank allows the Company certain overdraft privileges. The Company believes that the funds expected to be generated from operations, combined with net proceeds from its initial public offering will be sufficient to finance the Company's operations beyond fiscal 1991.

Bingham's statements in the Annual Report echoed this optimism, pointing out that the company's stock had gained $12.50 in value since its launch. Soon thereafter, Alias announced its earnings for the quarter ending April 30, 1991. Revenues for that quarter increased by 99% over the year before. Earnings for the quarter were reported to be $.10 per share, as compared to $.09 per share for the first quarter of 1990.

In late May and early June, two Alias vice-presidents sold thousands of their shares of Alias common stock at a price of $25 and above. On June 27, 1991, Bingham sold 175,000 shares, or about 40% of his Alias stock holdings, earning about $3.5 million.

On June 7, 1991, Alias disclosed on the Dow Jones news wire that the company had filed a Form S-1 Registration Statement with the SEC for the registration of 1.65 million shares of common stock. On June 27, 1991 (the same day as Bingham's $3.5 million stock sale), the public offering was indefinitely postponed "due to market conditions." On September 13, 1991, Alias announced yet another increase in revenues of about 113% over the same period in the previous year and a one-cent increase in earnings per share. These second-quarter figures were also reported in the Form 10-Q filed on September 16, 1991, with the SEC. In the Form 10-Q, Alias reported that "[the] increase in revenue [was] generally attributable to the increased efforts and expansion of the Company's direct sales force and increased efforts by the Company's distributor network."

This growth was offset by a $6,574,000 increase in accounts receivable, net of allowance for doubtful accounts, between January 31 and July 31, 1991. In the Form 10-Q, Alias attributed the problem to "an increased volume of business and the worldwide economic recession that [had] resulted in a slowing of collections, particularly from sales to international distributors." On the same day, September 16, 1991, the plaintiff-appellant Paul Stevelman purchased 1000 shares of Alias common stock for $15.50 per share.

On September 25, 1991, Alias announced, without explanation, that the vice-president in charge of its core division had resigned. Two days later, Alias announced that it expected to post a loss for its third quarter ending on October 31, 1991, without estimating the size of the loss. Bingham explained that the company "has experienced rapid growth and expansion" and it was "now taking steps to slow the pace and to manage [its] growth, including sales and receivables, more effectively." Upon the release of this news, Alias's stock price fell from $9.75 to $8.00. In December 1991, Alias filed its third-quarter Form 10-Q, which indicated a $5 million increase in allowances for doubtful accounts receivable. At the end of April 1992, Alias filed its Form 10-K for the fiscal year ending January 31, 1991. It disclosed for the first time that due to "a change in accounting policy," it was restating its results for the prior three quarters as reported in the Forms 10-K for those periods. The company said it had "changed its method for accounting for revenues from distributors in certain geographic areas" and would henceforth "recognize revenues from these distributors upon encryption [i.e., sale] of the software instead of upon shipment of the software tapes." The recalculation produced significant reductions in revenues for those periods, as well as a reduction in earnings for the first two quarters and an increase in losses for the third quarter. The 10-K also reported for the first time certain fourth-quarter "adjustments" including an additional allowance for uncollectible accounts receivable of $1.7 million.

In response to these announcements, Alias's stock price dropped significantly. A material factor in the reported losses was the "change" in accounting policy regarding recognition of revenues. During the period of time at issue here, Alias was recording "sales" and "revenues" when it delivered software to distributors who were then to sell the software to end-users. In his complaint, Stevelman alleges that the appellees knew or should have known or were reckless in not knowing that, at the time of their announcements of the positive revenue figures, there was no reasonable likelihood that Alias would receive timely payment (or even any payment) from these distributors for the software.

Industry standards and generally accepted accounting principles ("GAAP") require that a company's revenues not be recorded until such time as an exchange of merchandise has taken place and collection of the sales price on that merchandise is reasonably assured. Where there are substantial contingencies regarding payment for shipped merchandise, industry and GAAP standards mandate that recognition of revenue be deferred until such time as the payment is assured. Stevelman alleges that the defendant-appellees knew or should have known, or were reckless in not knowing, that their significant over-reporting of revenues violated basic accounting principles. In essence, Alias was counting consignment sales as actual sales and recording the anticipated revenue.

The Amended Complaint further alleged that Alias had filed materially misleading press releases and financial disclosure forms to the SEC. GAAP standards require accounts receivable to be stated at their estimated net realizable value to the company after provision for all known anticipated doubtful accounts. Under GAAP and industry standards, Alias should have established greater reserves against doubtful accounts, but it failed to do so, thus causing it to announce materially overstated earnings and revenues. Indeed, Alias's disclosure in its 1992 Form 10-K of its "change in accounting policy" reflected a change from non-compliance with industry and GAAP standards to compliance with those standards.

Stevelman filed a class action in the United States District Court for the District of Connecticut, alleging violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), derivative liability under section 20 of the Act, 15 U.S.C. § 78t(a), violation of SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, and common law fraud. Judge Burns dismissed the complaint without prejudice, ruling that Stevelman's complaint alleged only facts relating to corporate mismanagement, not fraud. Stevelman then filed an amended complaint, which Judge Burns ultimately dismissed with prejudice. She ruled that Stevelman's claims still described only "garden variety corporate mismanagement," without alleging the scienter element of actual fraud with sufficient particularity. Upon dismissal of Stevelman's federal claims, the District Court declined to exercise supplemental jurisdiction over his common law claim. ²

Discussion

This Court reviews de novo a district court's dismissal of a complaint pursuant to Fed.R.Civ.P. 9(b) and 12(b)(6) and accepts as true the facts alleged in the...