The opinion of the court was delivered by: John Gleeson, United States District Judge
This case arises out of claims brought by a group of seven hedge funds that purchased and sold millions of shares of Comverse Technology, Inc. ("Comverse" or "the Company") stock between 2001 and 2007. Plaintiffs previously opted out of a $225 million settlement of a related shareholder class action against Comverse ("the Class Action"), and now bring this action to pursue claims under Sections 10(b), 18 and 20(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78j(b), 78r and 78t(a), Securities and Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5, and New York common law. Defendants move to dismiss all of plaintiffs' claims. For the reasons stated below, defendants' motion to dismiss plaintiffs' Exchange Act claims and negligent misrepresentation claim against Comverse, Alexander, Kreinberg, Sorin, Friedman, Hiram and Oolie is granted insofar as plaintiffs' claims are based on defendants' 2007 statements and denied in all other respects. Defendants' motion to dismiss plaintiffs' negligent misrepresentation claim against Dahan and Aronovitz is granted.
The following allegations, taken from plaintiffs' complaint, are accepted as true for purposes of defendants' motion to dismiss.
Plaintiffs are a group of seven hedge funds (collectively referred to as "Maverick") that purchased shares of Comverse stock in 2005, 2006 and 2007. Defendants are Comverse, its officers, and members of its Compensation and Audit Committees. Comverse is a leading provider of software and systems that enable network-based communications service providers to offer enhanced communications services to their customers. Jaboc "Kobi" Alexander served as Chairman of Comverse's Board of Directors from September 1986 until his resignation on May 1, 2006, and also served as the Company's CEO from April 1987 until his resignation. David Kreinberg was the Company's CFO from May 1999 until his resignation on May 1, 2006. William Sorin served as General Counsel and then Senior General Counsel from October 1984 until his resignation on April 28, 2006. Alexander, Kreinberg and Sorin are collectively referred to as the "Officer Defendants." John H. Friedman served as a Director of Comverse from June 1994 through April 2007. Throughout the period from April 30, 2001 through November 14, 2006, Friedman served as Chairman of the Compensation Committee and as a member of the Audit Committee. Ron Hiram was a Director of Comverse from 1986 to 1987 and again from June 2001 through December 2006. Throughout the relevant period, Hiram was a member of the Compensation Committee and Chairman of the Audit Committee. Sam Oolie was a Director of Comverse from May 1986 through April 2007, and throughout that period, he served as a member of the Compensation Committee and the Audit Committee. Friedman, Hiram and Oolie are collectively referred to herein as the "Compensation/Audit Committee Defendants" or the "CAC Defendants." Andre Dahan has served as President, CEO and a member of the Board of Directors of Comverse from April 2007 through the present. Avi Aronovitz served as Comverse CFO from April 2006 through June 2008. Defendants Dahan and Aronovitz are collectively referred to as the "New Management Defendants."
A. The Stock Option Backdating Scheme According to the complaint, stock options and backdating, as relevant to the allegations in this case, function as follows.
Stock options enable employees to purchase company stock for a limited period of time at a specific price called the "exercise price." When the employee exercises the option, he or she purchases the stock from the company at the exercise price, regardless of the stock's price at the time the option is exercised. The exercise price is determined by the closing price of the stock on the "grant date."
A key purpose of employee stock options is to give employees an incentive to increase shareholder value by allowing them to benefit from an increase in the market price of the stock that occurs after the options are awarded. This purpose may be accomplished by awarding employees "at the money" stock options, meaning that the exercise price is equal to the market price of the stock at the time the option is awarded. When the grant date of an option is backdated to a date when the market price of the company's stock was lower than the current market price, the option is said to be "in the money" at the time the option is awarded because the exercise price is lower than the market price of the stock. While backdated "in-the-money" options still provide employees with an incentive to increase shareholder value, they also create an instantaneous paper profit for the option awardee. Options backdating is not illegal, but it must be accounted for correctly in a company's financial statements and properly disclosed to a company's shareholders.
Plaintiffs allege that, during the relevant period, Comverse granted stock options to the Officer Defendants and other employees pursuant to four different stock option plans (the "Plans"). Defendant Sorin drafted the Plans, which were approved by the Compensation Committee and then submitted to the Company's shareholders for approval by proxy vote. The Plans allowed for two types of stock options: (1) "incentive options" (as defined by § 422 of the Internal Revenue Code) and (2) "non-qualified options," which had different tax consequences. The Incentive Plan expressly provided in part:
The exercise price of Incentive Stock Options must not be less than the price of a share of Common Stock on the NASDAQ National Market System ("Fair Market Value") on the grant date.
(Compl. ¶ 51.) While the Plans allowed Comverse to grant "in-the-money" stock options for non-qualified grants, the Company represented that it never did so.
Comverse accounted for stock options using the method described in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), under which employers were required to record as an expense on their financial statements the "intrinsic value" of a stock option on its "measurement date." The measurement date, as defined by APB 25, is the first date on which the number of options that an individual employee is entitled to receive and the exercise price are known. If an option is "in the money" on the measurement date, the difference between its exercise price and the (higher) quoted market price must be recorded as a compensation expense to be recognized over the vesting period of the option. Options that are "at the money" on the measurement date need not be expensed.
In its Form 10-Ks filed with the SEC throughout the relevant period, Comverse consistently represented that its stock options had been accounted for in a manner consistent with GAAP. This was not true. In fact, the exercise prices for options granted through the end of 2001 (and which vested through 2005) were less than the fair market value of the underlying shares on the dates the grants were actually made, meaning that compensation expenses should have been recognized by the Company in connection with its stock-based compensation plans. Because Comverse did not record the difference in price as compensation, it did not account for the stock option grants in a manner consistent with GAAP. Comverse's failure to account for the difference between the fair market price and the actual exercise price not only impacted the Company's financial results, but also impacted its taxable income.
Plaintiffs allege that all defendants, with the exception of the New Management Defendants, were involved in the backdating scheme. Alexander directed and controlled the option grant process, initiated the backdating scheme, and personally chose the number of options to grant to himself and other senior officers. He selected the grant date by looking back at Comverse's historical stock prices and choosing a date on which Comverse's stock was trading at a relatively low price. Sorin advised the Compensation Committee and played a critical role in the scheme by drafting grant documents with backdated grant dates. Specifically, he, or someone acting at his direction, sent to the Compensation Committee members draft unanimous written consent forms containing "as of" dates. Those forms falsely indicated for each grant that corporate action sufficient to approve the grants had taken place on those "as of" dates when those dates had actually been determined after-the-fact in order to obtain a low exercise price. Starting no later than 1998, Kreinberg assisted Alexander in the scheme by, among other things, working with Alexander to select the backdated grant dates. The Compensation Committee approved the grants pursuant to the documents containing backdated grant dates. However, when the members of the Compensation Committee returned their individual copies of the consents to Sorin, they returned copies that had been signed but not dated. The Audit Committee was responsible for, among other things, overseeing the Company's financial reporting process and overseeing the Company's compliance with legal and regulatory requirements.
Overall, between 1991 and 2001, there were at least twenty-six backdated option grants to Comverse employees and employee-directors, including the Officer Defendants. The backdating scheme allowed the defendants to disguise the fact that the Company was paying higher compensation to executives and employees by awarding them in-the-money options. Bydoing so, the Company was able to avoid having to expense the in-the-money portions as a compensation expense and thus avoid reductions to the Company's net income and earnings per share.
Between 1991 and March 14, 2006, Comverse did not make any public disclosures regarding its backdating of options. To the contrary, the Form 10-Ks that Comverse filed with the SEC throughout the relevant period stated that its stock options had been accounted for in a manner consistent with GAAP. The defendants also concealed the existence of the backdating of options from the Company's outside auditors, Deloitte & Touche.
B. Additional Accounting Claims
Plaintiffs contend that the scheme was not limited to backdating stock options,alleging that it also included manipulating the published financial results to give the appearance that the Company was well managed. In order to accomplish this result, Alexander directed Kreinberg to make adjustments to quarter-end reserve accounts to create desired earnings per share, and to move expenses from one category to another as a way of ensuring that the Company's expenses would appear to grow in a measured and consistent manner. Alexander also directed Kreinberg to manipulate the sales backlog figures the Company reported in its annual reports on Form 10-K and to analysts in order to report numbers consistent with what Alexander believed Wall Street investors would view favorably. According to the SEC, Comverse's "fraudulent scheme . . . involved several improper earnings management practices that were not in conformity with GAAP." (Id. ¶ 129.)
Kreinberg and Alexander's accounting manipulations impacted reported financial results from 1996 through 2006, and the scope of the accounting fraud continues to prevent the Company from meeting its obligations to file restated and current financial statements with the SEC. As Dahan, Comverse's current CEO, recently described the problem: "The fraud was everywhere, in every accounting area of the Company."(Id. ¶ 127.)
On March 14, 2006, Comverse announced in a press release that its Board ofDirectors had formed a Special Committee of independent directors to investigate "the accuracy of the stated dates of option grants and whether all proper corporate procedures were followed." (Compl. ¶¶ 15, 134; Ex. H (3/14/2006 Comverse Form 8-K.) In response to this disclosure, plaintiffs allege that the price of Comverse stock fell $4.30 per share, losing 14.7% of its value on a single day of trading.
After reviewing Comverse's March 14, 2006 press release, representatives of Maverick spoke directly with Friedman later that same day. Friedman, in his capacity as a Comverse Director and Chairman of the Compensation Committee and a member of the Audit Committee, reassured representatives of Maverick that any problems at Comverse were strictly limited to stock option backdating similar to that being reported to have occurred at numerous other technology companies.
Over the course of the next few days, more information about the backdating allegations became available. On March 16, Standard & Poor's put Comverse on "credit watch" as a result of concerns about the Company's backdating scandal. That same day, the price of Comverse stock fell from $25.04 to $24.32, a drop of 2.88%. On March 18, The Wall Street Journal published an article discussing the suspicious timing of options awards for executives at a number of companies, including Comverse. On the next trading day after the article, the price of Comverse stock fell from $24.29 to $22.87, a drop of 5.85%.
One month later, on April 17, 2006, Comverse publicly reported "that it had engaged in improper backdating" of stock options and that it would restate its 2001-2005 financial statements. (Id. ¶¶ 144, 145; Ex. I (4/17/2006 Comverse Form 8-K).) The company warned investors that they should not rely on its prior financial statements, stating that "such financial statements and any related reports of its independent registered public accounting firm should no longer be relied on." (Id. ¶ 144; Ex. I.) The Company also reported that it would not timely file its Form 10-Q for its second quarter ending July 31, 2006, and that its investigation was still ongoing. But the Company reassured investors that the accounting impact of the backdating scheme would not change the reported operating cash results of the Company. Specifically, it stated: "The Company does not expect that the anticipated restatements would have a material impact on its historical revenues, cash position or non-stock option related operating expenses." (Id. ¶ 146; Ex. I.) Over the next two days of trading following the April 17 disclosure, the price of Comverse stock fell from $24.20 to $22.94, a drop of 5.21%.
On May 1, 2006, Comverse announced the resignation of its CEO (Alexander), CFO (Kreinberg) and General Counsel (Sorin). On May 4, 2006, Comverse publicly reported that it had received a subpoena from the Department of Justice ("DOJ") seeking records relating to its stock option grants between 1995 and 2006. That night, the Wall Street Journal web site reported that the DOJ had opened a criminal investigation into stock option backdating at Comverse. The next day, the price of Comverse shares fell from $24.03 to $22.98, a drop of 4.37%.
Over the next several months, more information regarding the effects of the options backdating scheme on the Company continued to emerge. On June 12, 2006, Comverse announced it would be unable to file its Form 10-Q for the quarter ended April 30, 2006. On August 9, 2006, defendants Alexander, Kreinberg and Sorin were all charged in a criminal complaint related to the alleged backdating of stock options. On November 14, 2006, the Company issued a press release warning that it had "identified errors in the recognition of revenue related to certain contracts, errors in the recording of certain deferred tax accounts and the misclassification of expenses in earlier periods." (Compl. ¶¶ 21, 166, Ex. N (11/17/2006 Comverse Form 8-K.) The release further stated: "The Special Committee's investigation continues, and the Company is unable to estimate the effect of the other accounting issues on its previously issued financial statements or the time it will take to complete the necessary restatements." (Id.)*fn1
Between September 12, 2006 and October 4, 2006, plaintiffs sold all of theirComverse shares.
On February 1, 2007, NASDAQ suspended trading in Comverse stock, and on June 1, 2007, it delisted the stock. Comverse stock has traded only in the over-the-counter securities market since February 1, 2007.
D. New Management Reassurances
Upon becoming the Company's CEO in April 2007, Dahan set out to reassure themarket that Comverse could regain compliance with SEC regulations and file current, audited financial statements. On June 11, 2007, in a press release subsequently filed on Form 8-K with the SEC and signed by the Company's general counsel and Chief Operating Officer, Paul L. Robinson, the Company stated: "The company expects to become current in its filings with the Securities and Exchange Commission by the end of fiscal 2007." (Id. ¶ 170.) Dahan made similar reassuring statements on analyst conference calls on June 20, 2007 and September 10, 2007, as well as on conference calls with plaintiffs as late as October 23, 2007. Aronovitz also participated in the June 20, 2007 and September 10, 2007 conference calls, and, at least on the June 20, 2007 call, reaffirmed the expectation that Comverse would be current with its SEC filings by the end of fiscal 2007. Relying upon the reassurances of the New Management Defendants, plaintiffs resumed purchasing Comverse shares on August 31, 2007.
On November 5, 2007, the Company disclosed that it would not be able to restate its financial results by the end of fiscal year 2007 because of rampant accounting improprieties. On the next trading day, the price of Comverse stock dropped from $19.25 to $17.49, a drop of 9.14%.
On April 19, 2006, a Comverse shareholder filed a putative class action against allof the current defendants, with the exception of the New Management Defendants, as well as several other defendants who are not parties in this case. Caiafa v. Comverse Technology, Inc. ...