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Police and Fire Retirement System of the City of Detroit v. SafeNet

August 5, 2009

POLICE AND FIRE RETIREMENT SYSTEM OF THE CITY OF DETROIT, PLYMOUTH COUNTY RETIREMENT SYSTEM, STATE-BOSTON RETIREMENT SYSTEM, AND MICHAEL GOLDE, ON BEHALF OF THEMSELVES AND ALL OTHERS SIMILARLY SITUATED, PLAINTIFFS,
v.
SAFENET, INC., ANTHONY A. CAPUTO, KENNETH A. MUELLER, CAROLE D. ARGO, THOMAS A. BROOKS, IRA A. HUNT, JR., BRUCE R. THAW, ARTHUR L. MONEY, SHELLEY A. HARRISON, AND ANDREW E. CLARK, DEFENDANTS.



The opinion of the court was delivered by: Honorable Paul A. Crotty, United States District Judge

OPINION & ORDER

The Police and Fire Retirement System of Detroit, Plymouth County Retirement System, the State-Boston Retirement System, and individual plaintiff Michael Golde ("Plaintiffs") instituted this securities-fraud class action against SafeNet Inc., six of the company's former directors, and three of its former officers ("Defendants"). The Consolidated Amended Class Action Complaint ("Complaint" or "CAC"), which is 349 paragraphs and 151 pages long, alleges that SafeNet repeatedly issued financial, proxy, and registration statements which were materially false with regard to stock-options backdating and non stock-options revenue recognition. Plaintiffs claim that the stock-option and revenue-recognition frauds inflated the value of SafeNet's shares, until the news of the improper accounting practices emerged, which caused the share price to plummet. Plaintiffs bring nine causes of action, which include claims under: (1) Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5; (2) Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a); (3) Section 14(a) of the Exchange Act, 15 U.S.C. § 78n(a), and Rule 14a-9, 17 C.F.R. § 240.14a-9(a); (4) Sections 11 and 12(a)(2) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77k & 77l; and (5) Section 15 of the Securities Act, 15 U.S.C. § 77o. Defendants move to dismiss the Complaint under Rules 12(b)(6) and 9(b) of the Federal Rules of Civil Procedure. For the reasons that follow, the Defendants' motions to dismiss are GRANTED in part and DENIED in part.

BACKGROUND

I. The Parties

Plaintiffs purportedly represent all persons or entities that purchased or acquired SafeNet stock during an extended 37-and-one-half month period running from March 31, 2003 through May 18, 2006 (the "class period"). Plaintiffs include three public pension funds which purchased nearly 264,000 shares of SafeNet common stock during the class period, plus one individual Plaintiff, Michael Golde, who purchased shares of common stock in Rainbow Technologies, Inc. ("Rainbow"), and exchanged his Rainbow shares for SafeNet stock when SafeNet acquired Rainbow (the "Rainbow acquisition") on March 15, 2004. (See CAC ¶¶ 20-24.) Golde also purchased additional shares of SafeNet stock following the Rainbow acquisition. Defendant SafeNet develops, markets, and sells hardware and software information security products and services used to protect digital communications and identities. During the class period SafeNet was a publicly traded company, but in April 2007 it was acquired by Stealth Acquisition Corporation and is now privately held. (Id. ¶ 25.)

Defendant Anthony Caputo was SafeNet's Chief Executive Officer and Chairman of the Board of Directors. He resigned from all company positions on October 18, 2006. Defendant Carole Argo was Senior Vice President and Chief Financial Officer of SafeNet from June 1999 through June 2004. From June 2004 through the end of the class period, she also was SafeNet's President and Chief Operating Officer, and beginning in April 2006 Argo was the acting interim Chief Financial Officer. Argo also resigned from all company positions on October 18, 2006. Defendant Kenneth Mueller was SafeNet's Senior Vice President, Chief Financial Officer and Treasurer for approximately 22 months from June 2004 until April 6, 2006, when he resigned from the company. (Id. ¶¶ 26-28.) The Complaint collectively refers to Caputo, Argo, and Mueller as the "Officer Defendants."

The Complaint also groups together various members of SafeNet's Board of Directors. Defendant Thomas Brooks was a SafeNet director and a member of the Compensation Committee and Audit Committee. Ira Hunt was a director and a member of the Audit Committee and Compensation Committee until 2004. Bruce Thaw was a director and a member of the Compensation Committee since 2004. Arthur Money joined the Board of Directors as part of the Rainbow acquisition and was a member of the Audit Committee and Compensation Committee after March 16, 2004. (Id. ¶¶ 31-34.) The Complaint collectively refers to Brooks, Hunt, Thaw, and Money as the "Compensation Committee Defendants." Defendants Shelley Harrison and Andrew Clark were not on the Compensation Committee, but signed various proxy and registration statements as SafeNet directors. The Compensation Committee Defendants, together with Harrison and Clark, are collectively referred to as the "Director Defendants."

Finally, the Complaint also groups the individuals who signed the registration statement related to the Rainbow acquisition. These Defendants-Caputo, Argo, Brooks, Thaw, Hunt, Harrison, and Clark-are referred to as the "Rainbow Acquisition Defendants." (Id. ¶ 40.)

II. The Allegations*fn1

The Complaint, although it stretches an extraordinary 151 pages, essentially alleges that Defendants made false and misleading statements in filings with the Securities and Exchange Commission ("SEC") and in registration, prospectus, and proxy statements.*fn2 Those false statements related to: (1) SafeNet's accounting practices for backdated stock-options grants; (2) SafeNet's accounting practices for recognizing revenue in product sales, unrelated to the stock-options backdating practices.

The Complaint contains nine counts naming different combinations of defendants: Count One: Against SafeNet, the Officer Defendants, and the Compensation Committee Defendants for stock-option misrepresentations in violation of Section 10(b) of the Exchange Act and Rule 10b-5.

Count Two: Against the Officer Defendants and the Compensation Committee Defendants for violations of Section 20(a) of the Exchange Act, relating to stock-options misrepresentations.

Count Three: Against SafeNet and the Officer Defendants for misrepresentations related to non stock-options revenue-recognition practices in violation of Section 10(b) of the Exchange Act and Rule 10b-5.

Count Four: Against the Officer Defendants for violations of Section 20(a) of the Exchange Act, relating to non stock-options revenue-recognition practices.

Count Five: Against SafeNet and the Director Defendants for misrepresentations in SafeNet proxy statements in violation of Section 14(a) of the Exchange Act and Rule 14a-9.

Count Six: Against SafeNet and the Rainbow Acquisition Defendants for misleading statements in the Rainbow proxy in violation of Section 14(a) of the Exchange Act and Rule 14a-9.

Count Seven: Against SafeNet and the Rainbow Acquisition Defendants for violations of Section 11 of the Securities Act.

Count Eight: Against SafeNet, Caputo, and Argo for violations of Section 12(a)(2) of the Securities Act.

Count Nine: Against the Rainbow Acquisition Defendants for violations of Section 15 of the Securities Act.

a. Stock Options Backdating

The Complaint alleges that SafeNet, through its officers and the Compensation Committee Defendants, issued hundreds of thousands of improperly accounted-for stock options grants. Under the accounting rules in effect prior to 2006, public companies could grant stock options to employees without recording the grant as a compensation expense, as long as the exercise price of the stock options was at or above the market closing price for the stock on the day the options were granted (so-called "at the money" options). If the exercise price for the stock options on the date selected was lower than the stock price on the award date (called "in the money" options), then the difference had to be recorded as a compensation expense. (Id. ¶ 43.) Accurate accounting of the compensation expense reduces the company's net income. (Id.) Backdating to an earlier date when the stock price was lower than the price on the record date has two results. First, the company's compensation expenses are lower than they ought to be, which has the effect of artificially inflating income. Second, the recipient of the backdated-in the money-options has a jump start on the market because of the low exercise price.

The Compensation Committee administered SafeNet's stock option plans and had the ultimate authority to grant the option awards. (Id. ¶ 48.) The plans provided that the Compensation Committee determined the exercise price of an option grant, which "in no event shall be less than 100% of the fair market value of [SafeNet's] Common Stock on the Grant Date." (Id.) The Compensation Committee approved option grants through Unanimous Written Consents ("UWCs") signed by Compensation Committee members. (Id. ¶ 49.) The Compensation Committee, however, took a secondary role in the granting of options; the Complaint alleges that the Officer Defendants generally initiated and oversaw the stock options grant process, selected the grant dates and exercise prices, selected the number of options granted, and provided the names of option recipients. (Id.)

In its proxy filings, SafeNet maintained that its stock options plan was "designed to align the executive's interests with that of the stockholders of the Company," and that "[n]o gain to the options . . . is possible without stock price appreciation, which will benefit all shareholders. If the stock price does not increase above the exercise price, compensation to the named executive will be zero." (Id. ¶ 47.) The allegations related to the false 10-K filings are repetitive, and one allegation will suffice as an exemplar. Plaintiffs allege, for instance, that in its 2003 Form 10-K, signed by Argo, Caputo, Brooks, Harrison, Hunt, and Thaw, SafeNet stated that "[o]ptions have been granted with exercise prices that are equal to the fair market value of the common stock on the date of grant." Plaintiffs allege that this form "was materially false and misleading when issued because . . . SafeNet in fact did issue options that were 'backdated,' so they were not issued at exercise prices 'equal to the fair market value of the common stock on the date of grant' and compensation expenses should have been recorded." (Id. ¶¶ 158-61.)

On October 5, 2007, Defendant Argo pled guilty to a single count of securities fraud in the Southern District of New York. In her plea allocution before Judge Rakoff, Argo stated that in mid-2000 she became responsible for overseeing SafeNet's stock options program. (Id. ¶ 58.) She stated that in December 2001 or January 2002, the Compensation Committee approved a grant to her and to two other individuals, including Caputo, and that Caputo asked Argo to report October 1, 2001, as the date of approval for the stock options. SafeNet's stock was at its lowest price for the quarter on October 1, 2001, and Argo admitted that she agreed to document Caputo's options as if they had been granted on that day, and the Compensation Committee approved that treatment. (Id.) Argo stated that she also documented the grant to herself and to another person as being granted on October 1, 2001, even though she and others knew that the Compensation Committee had not granted the options then. (Id.) Further, Argo stated that in following years, she and others backdated options grants while taking into consideration dates with low exercise prices. Because SafeNet did not record a compensation expense for these grants, SafeNet's public filings were incorrect. (Id.)

In addition to Argo's plea to a single count of securities fraud, the Complaint alleges that SafeNet made suspiciously timed grants to officers and employees from 1999 through 2005. Using charts and graphs to illustrate the dates of options grants, the Complaint alleges that SafeNet employees received hundreds of thousands of options grants on dates where SafeNet stock was trading at particularly low prices. (See id. ¶¶ 62-94.)*fn3 Plaintiffs allege that if SafeNet had properly recorded its compensation expenses during the class period, the company's actual net income would have been 355% lower in 2002, 36% lower in 2003, 71% lower in 2004, and 53% lower in 2005. (Id. ¶ 99.)

b. Non Stock-Options Revenue-Recognition Accounting Manipulations

Plaintiffs allege that during the class period, SafeNet and the Officer Defendants "engaged in pervasive improper revenue recognition activities and earnings manipulations to enable the [c]ompany to meet Wall Street analysts' expectations." (Id. ¶ 100.) The Complaint cites several confidential witnesses to allege that Argo, Caputo, and Mueller exerted substantial, unchecked pressure to make quarterly and annual earnings figures match Wall Street's expectations. (Id. ¶ 101-03.) The alleged manipulations fell into four categories:

1. Improper accounting for long-term development contracts. SafeNet stated in public SEC filings that it used an accounting method called "percentage of completion," where it recognized revenue over the life of a long-term contract based on the degree of completion. Under this principle, SafeNet should have been recording revenue as the company hit certain completion milestones. Naturally, the revenue booked would have to be offset by the actual costs incurred in meeting those milestones. The Complaint alleges that SafeNet later disclosed that it actually booked revenue on a "costs incurred" basis, which meant that it booked revenue based on a percentage of budgeted costs incurred. By underestimating the total cost of a project, SafeNet could book revenue based on when those costs occurred. Since there would be a smaller offset in recorded costs, SafeNet's total reported profit increased. In this way SafeNet frontloaded revenue and hid costs on long-term projects until later dates. (Id. ¶¶ 106-22.)

2. Improper revenue recognition on "bill and hold" transactions. In bill and hold transactions a company bills a customer for products, but does not ship the products until a later date. The Complaint alleges that such a transaction is only allowed under certain conditions, including that the buyer must request the transaction and the product must be ready to ship at the time of billing. SafeNet allegedly recognized revenue under a bill and hold method when the products were still in the testing stage or were otherwise unavailable for shipping. (Id. ¶¶ 123-28.)

3. Improper recognition of revenue upon shipment of unfinished products. In addition to billing for incomplete and unshipped products, the Complaint alleges that SafeNet shipped some unfinished products to customers at the end of fiscal periods to recognize revenue on such "sales," even though SafeNet would have to accept the return of those products and reverse the sales in future quarters. (Id. ¶¶ 129-32.)

4. Improper recognition of revenue on royalty payments. Plaintiffs allege that SafeNet improperly accelerated the collection of royalties by asking companies to prepay longterm royalties in return for an overall discount on the amount owed. Plaintiffs allege that this harmed investors who anticipated higher future royalty revenues. (Id. ¶¶ 133-36.)

c. Misstatements Related to the Rainbow Acquisition

Plaintiffs allege that SafeNet's misstatements specifically harmed shareholders of Rainbow stock. Plaintiffs allege that SafeNet was able to complete the Rainbow acquisition on certain financial terms by misleading Rainbow shareholders about SafeNet's stock-options granting and revenue recognition practices.

The Rainbow acquisition involved a stock-based merger where Rainbow shareholders exchanged each share in their company for 0.374 SafeNet shares, receiving 43% of the total shares of the combined companies. (Id. ¶ 14.) Plaintiffs allege that that the defendants who signed the Rainbow registration and proxy/prospectus "solicited the affirmative vote of Rainbow's shareholders in favor of the Rainbow Acquisition and caused the [merger at the 0.374 exchange rate] by issuing a materially false and misleading registration statement . . . which incorporated a false and misleading joint proxy statement/prospectus." (Id. ¶ 15.) The Rainbow registration statement and proxy/prospectus, filed with the SEC on February 11 and 12, 2004, allegedly contained false statements about SafeNet's financial condition and about the company's practice in granting stock-options. (Id. ¶¶ 153-57.)

III. The Alleged Disclosures of the Fraud During the Class Period

Plaintiffs allege that the truth about SafeNet's backdating and improper revenue recognition practices emerged in three corrective disclosures during the class period: SafeNet press releases dated February 2, 2006, April 6, 2006, and May 18, 2006. SafeNet's stock dropped immediately after each press release.

On February 2, 2006, SafeNet issued a 12-page press release reporting its year-end and fourth-quarter financial results for 2005. (Id. ¶ 212; Declaration of Andrew Reynard ("Reynard Decl.") Ex. 1.) At page eight, the release announced that SafeNet would be restating its previously disclosed earnings for the second and third quarters of 2005. The release stated:

During the year end audit process, we discovered errors that impacted prior quarters but did not materially impact the full year results. One error occurred during the second quarter of 2005 which consisted of an understatement of lease restructuring charges of approximately $700,000. Another error of approximately $600,000 was related to an understatement of our costs of revenues in our Classified Government business in the third quarter of 2005. These errors will be corrected in a 10-Q/A filing shortly.

(CAC ¶ 213; Reynard Decl. Ex. 1 at 8.)

Plaintiffs also allege that during a conference call that same day, SafeNet disclosed that its auditors had reviewed SafeNet's revenue recognition policies and concluded that the company needed to defer recognition of $1 million in revenue that SafeNet had planned to recognize in the fourth quarter of 2005. (CAC ¶ 213.) SafeNet's stock fell 15.2% on February 3, 2006, from $32.72 to $27.75, on a heavy volume of trading. (Id. ¶ 217.)

On April 6, 2006, SafeNet announced in a press release that CFO Mueller was "leaving the company as of today." (Id. ¶ 223; Reynard Decl. Ex. 2.) The release stated that Argo would step in as the interim CFO and continue as SafeNet President. The release also revised SafeNet's projection for 2006 first quarter revenues to $63 to $65 million, down from the company's February 2, 2006 projection of $65 to $69 million. In a separate news release on that day, SafeNet announced that it was abandoning a proposed acquisition of nCipher plc because regulatory authorities in the United Kingdom requested further review of the deal. (Reynard Decl. Ex. 3.) SafeNet stock fell 19.3% on April 7, from $25.97 to $20.96, again on a heavy volume of trading. (CAC ¶ 224.)

On May 18, 2006, the last day of the class period, SafeNet issued a press release stating that:

[SafeNet] received a subpoena from the office of the United States Attorney for the Southern District of New York relating to the Company's granting of stock options. The Company also announced that it has received an informal inquiry from the Securities and Exchange Commission requesting information relating to stock option grants to directors and officers of the Company, as well as information relating to certain accounting policies and practices. (CAC ¶ 226; Reynard Decl. Ex. 4.)

SafeNet's stock dropped 22.3% on May 19, from $19.21 to $14.93, the second-largest percentage decline of any stock on the NASDAQ ...


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