Opinion
Civil Action No. 00-10322-RWZ
August 26, 2002
MEMORANDUM OF DECISION
Plaintiffs are investors who purchased stock in Xchange, Inc. ("Xchange"), a publicly traded software company, between December 9, 1998, and September 29, 2000. They allege that the company, its officers, and its auditors knowingly used an inappropriate revenue recognition model in order to manipulate and artificially inflate the company's reported earnings. Specifically, they claim that Xchange was required to use "contract accounting," which measures incremental revenue over time, because the company's software products often require substantial modification and installation over the course of many months; instead, they say Xchange fraudulently recorded revenue using "out-of-the-box accounting," which recognizes all revenue from one contract on the date of that contract.
Plaintiffs filed a class action complaint on February 21, 2001, against Xchange and four of its officers, Andrew J. Frawley, F. Daniel Haley, David F. McFarlane and Robin Green asserting two counts of securities fraud: (1) violation of 15 U.S.C.S. § 78j(b) ("Exchange Act § 10(b)"), and 17 C.F.R. § 240.10b-5 ("Rule 10b-5"), and (2) violation of 15 U.S.C.S. § 78t(a) ("Exchange Act § 20(a)"). The complaint described numerous misstatements by Xchange officers between July 24, 2000, and September 29, 2000, when an Xchange press release revealed that the company was switching to "contract accounting" for certain transactions. Six months later, on August 3, 2000, plaintiffs filed an amended complaint adding two new defendants (Xchange's auditors, Arthur Anderson ("AA"), and Xchange's Chief Financial Officer, John G. O'Brien) and three new claims. The amended complaint alleges: violation of Exchange Act § 10(b) and related Rule 10b-5 by Xchange and its five officers (Count I); violation of Exchange Act § 20(a) by the five individual officers (Count II); violation of Exchange Act § 10(b) and related Rule 10b-5 by Arthur Anderson (Count III); violation of 15 U.S.C.S. § 77k(a) ("1933 Act § 11") by Xchange, its five officers and Arthur Anderson (Count IV); and violation of 15 U.S.C.S. § 77o ("1933 Act § 15") by the five individual officers (Count V). The first two claims are identical to those in the original complaint, except that they add defendant O'Brien; the last three claims are newly raised in the amended complaint.
Defendants Xchange and AA have moved for dismissal on numerous grounds. They argue initially that the statute of limitations bars all claims first raised in the amended complaint either against AA or under § 11 and § 15 of the 1933 Act. The parties agree that the applicable statute of limitations for actions under the Exchange Act and the 1933 Act is one year from the date when the plaintiffs knew or should have known of their injury. They disagree about the date the cause of action accrued: plaintiffs insist that the statute began to run on September 29, 2000, when they received actual notice of the alleged fraud in the form of Xchange's announcement that it was switching to "contract accounting" for certain transactions, whereas defendants argue that the limitations period started to run by March or April of 2000, when plaintiffs had ample information to discover their claims.
At various points in their briefs, plaintiffs refer to the date of actual notice as both September 29, 2000 (when Xchange announced that it expected low third quarter results, in part because it would be using the contract accounting method for some transactions) and October 2, 2000 (when Xchange announced its actual third quarter results, elaborating on its shift to contract accounting). I will continue to use the September 29, 2000, date for the sake of consistency, particularly as there is no difference between the dates for purposes of a statute of limitations analysis.
The relevant question in determining the statute of limitations for a securities fraud action is not when plaintiffs actually learned of the fraud, but rather when they should have discovered it through reasonable diligence. "`Storm warnings' of the possibility of fraud trigger a plaintiff's duty to investigate in a reasonably diligent manner . . . and his cause of action is deemed to accrue on the date when he should have discovered the alleged fraud." Cooperative de Ahorro Y Dredito Aguada v. Kidder, Peabody Co., 129 F.3d 222, 224 (1st Cir. 1997) (citing Maggio v. Gerard Freezer Ice Co., 824 F.2d 123, 128 (1st Cir. 1987)).
The complaint describes a number of "storm warnings" which put the plaintiffs on inquiry notice of their claims long before September 29, 2000. Most notable is the widely-publicized accounting controversy that took place in early 2000 regarding the accounting for a contract between Xchange and its competitor, MicroStrategy. The contract, dated December 28, 1999, was recorded by both companies in the fourth quarter of 1999 and made up a large percentage of both companies' revenue for that quarter. In early 2000, MicroStrategy announced that the contract had been improperly reported and should have been recorded in the first quarter of 2000; it restated its fourth quarter 1999 results, and announced that it would restate its revenue for the prior three years using "contract accounting" in order to properly recognize incremental revenue over time. MicroStrategy's stock subsequently plummeted from $226 per share to $74 per share in two days. Investors sued both MicroStrategy and its auditors, PricewaterhouseCoopers, based on the improper revenue recognition.
MicroStrategy's announcements prompted considerable press coverage regarding the contract between Xchange and MicroStrategy. Analysts publicly questioned whether Xchange, too, had misreported the contract revenue in order to manipulate quarterly earnings. Xchange stood by its revenue statements and did not restate its earnings for the MicroStrategy contract, emphasizing that its auditors had approved the accounting. Nevertheless, Xchange's stock also experienced a dramatic (albeit more gradual) drop in value from a high of $67.44 per share on March 28, 2000, to only $12.19 per share on April 28, 2000.
Each of these "storm warnings" — a public controversy over the accounting for one of Xchange's biggest contracts, Xchange's failure to restate revenue from the contract after MicroStrategy did so, and the subsequent sharp drop in Xchange's stock price — occurred by late April of 2000 and triggered the plaintiffs's duty to investigate the possibility of fraud. Since the facts underlying plaintiffs' fraud claims — that Xchange used "out-of-the-box accounting," that its software products were frequently modified and installed over long periods of time, and that accounting guidelines require such contracts to be recognized under the "contract accounting" method — were matters of public record, plaintiffs are charged with such knowledge. They thus should have known of their claims against Xchange and its auditors by April 2000 at the latest.
Plaintiffs argue that, even if this is so, the statute of limitations was tolled until September 29, 2000, when they had actual notice of their claims, because Xchange fraudulently concealed its fraud by "fail[ing] to disclose that out-of-the-box accounting was an inappropriate method for recognizing Xchange's revenue." However, this Circuit has held that, "[i]rrespective of the extent of the effort to conceal, the fraudulent concealment doctrine will not save a charging party who fails to exercise due diligence, and is thus charged with notice of a potential claim." Truck Drivers Helpers Union v. National Labor Relations Board, 993 F.2d 990, 998 (1st Cir. 1993). Since Xchange's accounting method, the nature of its software products and contracts, and the relevant accounting guidelines were matters of public knowledge, plaintiffs did not exercise due diligence in investigating their claims. Accordingly, they may not claim fraudulent concealment, and the statute of limitations began to run in April 2000 when plaintiffs had sufficient knowledge to trigger a duty to investigate.
Plaintiffs filed their first complaint on February 21, 2001, well within the statute of limitations. The amended complaint, which added new claims and new defendants, was filed on August 3, 2001, after the one-year statute of limitations had run. Thus, the new claims are time-barred unless they relate back to the original complaint. Under Federal Rule of Civil Procedure 15(c)(3), an amendment adding a new party relates back to the filing of the original complaint only if three requirements are met: (1) "the claim or defense asserted in the amended pleading arose out of the conduct, occurrence or transaction set forth or attempted to be set forth in the original pleading;" (2) the new party "has received such notice of the institution of the action that the party will not be prejudiced in maintaining a defense on the merits;" and (3) the new party `knew or should have known that, but for a mistake concerning the identity of the proper party, the action would have been brought against [him].'" Rule 15(c)(3).
With respect to AA, the first element is easily satisfied because the claims raised against AA in the amended complaint involve the same allegedly fraudulent revenue statements and earnings reports that served as the basis for the claims against Xchange and its officers in the original complaint. Plaintiffs maintain that the second element is also satisfied because, as Xchange's auditors, AA would necessarily have been informed of this class action as a contingency to be accounted for in the company's financial statements. Whether or not this is the case, it is clear that the third element of Rule 15(c)(3) is not satisfied — the plaintiffs' failure to name AA in the original complaint was not the result of a mistake in the identity of the proper party.
Rule 15(c)(3) enables plaintiffs to correct their pleadings and add defendants whom they would have named in the original complaint, if not for a mistake regarding identity or proper name. It does not protect plaintiffs who knew of the late-named party at all times but failed to include that party in the original filing. "What the plaintiff knew (or thought he knew) at the time of the original pleading generally is the relevant inquiry in respect to the question of whether a mistake concerning identity actually took place." Leonard v. Parry, 219 F.3d 25, 29 (1st Cir. 2000).
The amended complaint states that, before September 29, 2000, Xchange and its officers "repeatedly assured investors that [it had] appropriately accounted for the [MicroStrategy] transaction and Defendant AA had confirmed this." Thus, according to their own allegations, plaintiffs knew at the time they filed the original complaint, from statements by defendants, that AA had reviewed and approved Xchange's allegedly fraudulent revenue reports. Nothing prevented plaintiffs from naming AA in the original complaint; they simply overlooked a rather obvious defendant. Under these circumstances, AA had insufficient notice of the claims against it because it might have reasonably concluded that plaintiffs deliberately chose to omit Xchange's auditors from the action for tactical reasons. Accordingly, the claims against AA do not relate back and are time-barred.
The other new defendant, Mr. O'Brien, is in a different position. The claims against him satisfy all three requirements of Rule 15(c)(3): first, they involve the same conduct and transactions as those claims raised in the original complaint; second, as chief financial officer, O'Brien has an identity of interest with the company and is presumed to have received notice of this action as soon as it was brought, Serrano v. Gonzalez, 909 F.2d 8, 12 (1st Cir. 1990) (citing Hernandez Jiminez v. Astol Calero Toledo, 604 F.2d 99, 102-03 (1st Cir. 1979)); finally, given that the original complaint named Xchange's chief executive officer, chief strategy officer, chief operating officer and senior vice president, Mr. O'Brien should have known, as the only corporate officer not named in the original complaint, that he was omitted by mistake. Therefore, the claims against him do relate back.
Defendants also challenge for lateness the new claims under the 1933 Act. Counts IV and V allege that defendants filed false or misleading registration statements in connection with Xchange's IPO on December 9, 1998, and Second Offering on June 4, 1999. Since these claims were added after the one-year statute of limitations had passed, they, too, are time-barred unless they relate back to the original complaint.
A new claim relates back to the date of the original pleading if the claim "arose out of the conduct, transaction or occurrence set forth . . . in the original pleading." Rule 15(c)(2). By definition, plaintiffs' new claims under § 11 and § 15 the 1933 Act involve misstatements made in Xchange's registration statements. Yet, the original complaint made no reference to Xchange's December 1998 IPO or June 1999 Second Offering, nor did any allegations concern the registration statements for those offerings. Indeed, that complaint did not assert any fraud prior to July 24, 2000, but limited its allegations to various financial reports and public announcements made by defendants between July 24, 2000, and September 29, 2000. Based on these narrowly-drawn allegations, defendants could not have anticipated that this action would reach as far back in time as the IPO and Second Offering. Because the new claims are not supported by any conduct, transaction or occurrence alleged in the original complaint, they do not relate back and are dismissed as time-barred.
Defendants have urged several other grounds for dismissal. They argue (1) that plaintiffs failed to satisfy the strict pleading requirements; (2) that they failed to identify any misstatement by defendants; (3) that the allegedly false and misleading statements were not material; (4) that the complaint is written in a "disjointed style" that violates pleading requirements; and (5) that plaintiffs lack standing to bring 1933 Act claims because they have not established that their stock can be traced back to the IPO or Second Offering. The amended complaint, read in the light most favorable to the plaintiffs, sufficiently alleges material misstatements on the part of the defendants and meets the relevant pleading requirements. Defendants' first four arguments are thus unavailing. I need not consider whether defendants' fifth argument (that plaintiff lack standing to bring claims under the 1933 Act) has merit, because Claims IV and V are dismissed as time-barred.
For the reasons stated above, defendants' motion to dismiss is ALLOWED as to Counts III, IV and V, and DENIED as to Counts I and II.