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United States District Court, Southern District of New York

January 31, 2000


The opinion of the court was delivered by: Baer, District Judge.


The plaintiffs bring this class action lawsuit against defendant corporation N2K, Inc. ("N2K") and six named officers of N2K for alleged violations of Sections 11 and 15 of the Securities Act of 1933, 15 U.S.C. § 77k and 77o, in connection with the plaintiffs' purchase of common stock sold by N2K in a public offering on April 15, 1998.*fn1 The defendants move pursuant to Fed.R.Civ.P. 12(b)(6) to dismiss the consolidated amended class action complaint. For the reasons discussed below, the defendants' motion is GRANTED.


The well-pleaded facts of this case, taken as true on this motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6), are as follows:

N2K is a Delaware corporation with principal executive offices in New York City and is an on-line music retailer that uses the internet for promoting, marketing and selling music and merchandise via its website, known as "Music Boulevard." Defendant Laurence Rosen ("Rosen") is the chief executive officer of N2K and Chairman of its Board of Directors. Defendants Jonathan Diamond ("Diamond") and Robert Grusin ("Grusin") are both vice chairmen and directors of N2K. Defendant James Coane ("Coane") is president, chief operating officer, and a director of N2K. Defendant Bruce Johnson ("Johnson") is chief financial officer, secretary, treasurer, senior vice president, and a director of N2K. Defendants Robert Harris ("Harris") and Susanne Harrison ("Harrison") are directors of N2K. All individual defendants were directors and/or senior executive officers of N2K, and were signatories to the registration statement disseminated in connection with the public offering at issue here.

The plaintiffs and other class members are purchasers of N2K common stock sold in connection with the April 15, 1998 offering.

On August 7, 1997, N2K filed a registration statement with the SEC for an initial public offering (the "IPO") of 3,330,221 shares of common stock at $19.00 per share. The IPO was completed on October 17, 1997. By March 1998, N2K sought to raise additional capital through a secondary offering (the "offering") of its common stock. On March 4, 1998, N2K filed a registration statement and preliminary prospectus with the SEC for the sale of just over 3.1 million shares of common stock. Included with these documents were N2K's annual financials for the years 1994 through 1997, and quarterly results for the periods between March 31, 1996 and December 31, 1997. The registration statement was later declared effective on April 14, 1998. It did not include N2K's first quarter results for the quarter ending March 31, 1998, a key factor in this litigation.

On April 15, 1998, pursuant to the registration statement and prospectus, N2K completed the offering of 3,125,722 shares of common stock at $33.00 per share. The company received gross revenues from this secondary offering of approximately $60 million, roughly $16 million more than was anticipated at the time the registration statement was filed.*fn2

N2K announced on April 23, 1998 its results for the quarter ending March 31, 1998, this announcement coming twenty-three days after the quarter ended and nine days after the effective date of the registration statement. The company reported revenues of $7,031,000 and a net loss of $13,704,000, a loss of $1.13 per share, nine cents more per share than analysts' expectations. By the end of trading on April 24, 1998, the price for N2K's shares had fallen nearly $8 per share to close at $25 1/4. As of the date of the complaint, the price of N2K's common stock had not recovered and had, in fact, slipped to $13 13/16 per share.

The plaintiffs maintain that at the time the registration statement became effective on April 14, 1998, the defendants possessed undisclosed information regarding N2K's revenues, expenses, and losses for the first quarter of 1998. The defendants deny any such knowledge and rely in part on the fact that said financials were released when they became available on April 23, 1998. The amended complaint alleges that the defendants' possession of this information*fn3 is evidenced by N2K's having "release[d] accurate financial results for the fourth quarter and year ended December 31, 1997 . . . just twelve days after the close of those reporting periods."*fn4 (Compl. ¶ 49.) The defendants therefore knew, the argument continues, at the time the registration statement became effective that N2K's first quarter numbers failed to meet analysts' expectations which, when disclosed to investors, would likely cause a significant decline in the price of N2K shares. According to the plaintiffs, since the price of N2K's stock was likely to be "materially adversely affected" upon public disclosure, the defendants — hoping to maximize the revenue received from the offering — concealed the first quarter information by not including it in the registration statement and prospectus.

The plaintiffs commenced this suit on May 8, 1998, and filed their consolidated amended class action complaint on August 4, 1998. The first cause of action is brought against all defendants, pursuant to Section 11 of the Securities Act ("Section 11"), 15 U.S.C. § 77k, based upon the omitted financial data. The second cause of action is brought against the individual defendants, pursuant to Section 15 of the Securities Act ("Section 15"), 15 U.S.C. § 77o, which imposes derivative liability upon "controlling persons" for violations of Section 11 by N2K.


A. Standards for Motion to Dismiss

Dismissal of a complaint pursuant to Rule 12(b)(6) is permitted "only where it appears beyond doubt that the plaintiff can prove no set of facts in support of the claim which would entitle him to relief." Scotto v. Almenas, 143 F.3d 105, 109-10 (2d Cir. 1998). "The task of the court in ruling on a Rule 12(b)(6) motion is `merely to assess the legal feasibility of the complaint, not to assay the weight of the evidence which might be offered in support thereof.'" Cooper v. Parsky, 140 F.3d 433, 440 (2d Cir. 1998) (quoting Ryder Energy Distribution Corp. v. Merrill Lynch Commodities, Inc., 748 F.2d 774, 779 (2d Cir. 1984)). In deciding a 12(b)(6) motion, the Court must accept as true all material facts alleged in the complaint and draw all reasonable inferences in the nonmovant's favor. See Thomas v. City of New York, 143 F.3d 31, 36 (2d Cir. 1998). On a motion to dismiss a complaint brought under the securities laws, the Court may properly consider documents, such as the prospectus at issue, which are incorporated into the complaint by reference. See Brass v. American Film Technologies, Inc., 987 F.2d 142, 150 (2d Cir. 1993).

B. Elements of Section 11

Section 11 of the Securities Act of 1933 creates a private remedy for any purchaser of a registered security if any part of the registration statement,

when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading. . . .

15 U.S.C. § 77k(a). Thus, a material omission from a registration statement is actionable if the omitted facts (1) were required by SEC regulations to be stated therein, or (2) were necessary to make the disclosures in the registration statement not misleading.

1. SEC Regulations

The relevant SEC regulations answer the question as to what material facts are required to be stated in an issuer's registration statement and prospectus. Article 3 of Regulation S-K, entitled "Supplementary financial information" requires disclosure of, inter alia, net sales, gross profit, and net income or loss "for each full quarter within the two most recent fiscal years and any subsequent interim period for which financial statements are included or are required to be included by Article 3 of Regulation S-X [17 C.F.R. § 210]." 17 C.F.R. § 229.302(a)(1). It is undisputed that the defendants provided the requisite information for each full quarter from March 31, 1996 through December 31, 1997. The sticky wicket here is whether Article 3 of Regulation S-X required N2K's financial information ("interim financial information") for the interim period of January 1, 1998 through March 31, 1998 (the "interim period"). The defendant argues that it did not, and I agree.

Article 3 of Regulation S-X requires the inclusion of interim financial information where the financial information in a registration statement is old or "as of a date 135 days or more prior to the date the [registration statement] is expected to become effective." 17 C.F.R. § 210.3-12(a). N2K's registration statement was declared effective on April 14, 1998; thus, only if the financial statements therein were "as of" November 28, 1997 or earlier — 135 days or more prior to April 14, 1998 — would the disclosure of the company's first quarter results be required under this rule. Unfortunately for the plaintiffs, the financial statements in N2K's registration statement were "as of" December 31, 1997 and therefore well within the 135-day window.

The plaintiffs contend that, in addition to the information expressly required by these regulations, the defendants were required under SEC Rule 12b-20 to include the 1998 first quarter financial data as information "necessary to make the required statements, in the light of the circumstances under which they are made, not misleading." 17 C.F.R. § 240.12b-20.*fn5 As the defendants correctly point out, however, Rule 12b-20 is inapplicable since it was promulgated under the Securities and Exchange Act of 1934, a different statute than the one at issue in the instant case. Although not cited by either party, the SEC has promulgated a regulation under the Securities Act of 1933 that is identical to its 12b-20 counterpart. See 17 C.F.R. § 230.408. While applicable, it is to no avail since here the statements were not misleading.

The plaintiffs also rely on case law to support its position that the defendant was required to disclose the interim financial information. Plaintiffs cite Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996), which held that an issuer in possession of nonpublic information was required in connection with a public offering to disclose known adverse facts about a quarter that had not yet ended. The duty to disclose arose in Shaw because the nonpublic information at issue represented "an extreme departure from the range of results which could be anticipated based on currently available information. . . ."*fn6 Id. at 1210 (emphasis added). Here the defendants' actual losses for the interim period in question were not beyond the range of plausible results based on available information at the time of the offering. Although the defendants had announced sizeable increases in revenues for the quarter and calendar year ending December 31, 1997, those figures were undoubtedly tempered, if not overshadowed, by N2K's net losses over those same periods. While net revenues increased from $1,115,000 to $4,755,000 between the first and fourth quarters of 1997, the material submitted to the SEC show net losses jumped from $4,518,000 to $13,196,342 during the same time period. Perhaps even more telling is that between the third and fourth quarters of 1997, N2K's net revenues increased by approximately 33 percent, while net losses jumped by nearly 250 percent.*fn7 Given these obvious trends, along with the many pages of explicit warnings and risk factors contained in N2K's prospectus, the information N2K possessed about its first quarter 1998 financial data — that its net loss had increased from $13,196,000 to $13,704,000 — cannot reasonably be characterized as an "extreme departure" from the range of anticipated results so as to make actionable N2K's omission of this nonpublic data from its registration statement.*fn8

In light of the foregoing, disclosure of the interim financial information for the quarter ending March 31, 1998 was not explicitly required under Section 11 and the regulations promulgated thereunder.

2. Information Otherwise Necessary to Make the Registration Statement Not Misleading

The plaintiffs submit that N2K's failure to disclose its first quarter results of 1998 until after the offering rendered the registration statement and prospectus misleading. More specifically, the defendants' alleged knowledge at the time of the offering of its net losses for the first three months of 1998 made the following disclosure — contained in the prospectus under the section entitled, "Potential Fluctuation In Quarterly Results" — false and misleading:

Due to all the foregoing factors, it is possible that in some future quarter or quarters the Company's operating results will be below the expectations of securities analysts and investors. In such event, the price of the Common Stock would likely be materially adversely affected.

(Prospectus at 12 — 13.) The plaintiff argues that this statement is misleading in that N2K's financial results were below analysts' expectations, and that the defendants knew this fact at the time the registration statement became effective. I disagree.

In examining claims under Section 11, the prospectus at issue must be read "as a whole." Olkey v. Hyperion 1999 Term Trust, Inc., 98 F.3d 2, 5 (2d Cir. 1996) (citation omitted), cert. denied, 520 U.S. 1264, 117 S.Ct. 2433, 138 L.Ed.2d 194 (1997). Additionally, the central inquiry to determine whether a prospectus is materially misleading is "whether the defendants' representations, taken together and in context, would have mis[led] a reasonable investor about the nature of the [securities]" Id; see also I. Meyer Pincus & Associates, P.C. v. Oppenheimer & Co., Inc., 936 F.2d 759, 761 (2d Cir. 1991).

It can hardly be said that, by having not been explicitly told of the company's actual first quarter losses, a reasonable investor would have been misled about the nature of N2K's securities. N2K's prospectus is replete with warnings and explanations of risks associated with the company's past financial history and future expectations. The third paragraph on the cover of the prospectus states in large, bold print, "These securities involve a high degree of risk." On page 5, the prospectus warns potential investors to consider the many risk factors discussed within the document, including "historical and anticipated losses." (Prospectus at 5 (emphasis added).) A few pages later in the document, this warning is discussed in full:

The Company has incurred significant losses and expects to continue to incur significant losses on a quarterly and annual basis for the foreseeable future . . . The Company currently intends to increase substantially its operating expenses as a result of the Company's strategic alliances, to fund increased sales and marketing, to enhance existing websites and to implement strategic relationships important to the success of the Company. To the extent that such expenses precede or are not subsequently followed by increased revenues, the Company's business, results of operations and financial condition will be materially adversely affected. The Company expects negative cash flow from operations to continue for the foreseeable future as it continues to develop and market its business.

(Id. at 8 (emphasis added.)) Thus, the prospectus not only warns prospective investors of possible losses in the future, but flatly states that the company fully expects "significant" losses to continue "on a quarterly and annual basis" for the "foreseeable future." Read in conjunction with the trends reflected by the graphical depictions on page 25 of the prospective, outlined in footnote 7 herein, and given that this prospectus became effective within two weeks of the quarter's end, a reasonable investor would have been well aware of the reality of continuing and sizeable losses for the coming quarters and coming year or years. See I. Meyer Pincus & Associates, 936 F.2d at 762 ("the prospectus states exactly the `fact' that [the plaintiff] contends has been covered up"); Olkey, 98 F.3d at 5 ("The prospectuses warn investors of exactly the risk the plaintiffs claim was not disclosed."); Hinerfeld v. United Auto Group, 1998 WL 397852, at *4 (S.D.N Y July 15, 1998) ("Courts will dismiss claims under [Sections 11 and 15] if they charge omissions of what was in fact disclosed."). Additionally, the implicit argument in the plaintiffs' position — that N2K's financial standing would meet or beat Wall Street's expectations — cannot be reasonably inferred in light of the warnings discussed above and the others in the prospectus.*fn9 The prospectus was therefore not made materially misleading by the defendants' omission of its financial data for the first quarter of 1998. Accordingly, the plaintiff has failed to state a claim upon which relief can be granted,*fn10 and the defendants' motion to dismiss both against the corporation and the individual defendants is GRANTED.


For the reasons discussed above, the defendants' motion to dismiss is GRANTED, and the plaintiff's complaint in DISMISSED with prejudice. The Clerk of the Court is directed to close this case. SO ORDERED.

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