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Sanford Gould, Individually, and On Behalf of All Others Similarly Situated v. Winstar Communications

July 19, 2012

SANFORD GOULD, INDIVIDUALLY, AND ON BEHALF OF ALL OTHERS SIMILARLY SITUATED, YAN SUN, BULLDOG CAPITAL MANAGEMENT LP, KEVIN SHERMAN, MAX C. MICHAELS, ROBIN KWALBRUN, ELEANORE REZNICK, FRANK ZAPPARIELLO, THEODORE S. GUTOWICZ, DAVID RICH, RICHARD SULENTIC, ANDRES RIOS, PLAINTIFFS, AND BIM INTERMOBILIARE SGR, A WHOLLY- OWNED SUBSIDIARY OF BANCA INTERMOBILIARE DI INVESTIMENTI E GESTIONI SPA, ROBERT AHEARN, DRYE CUSTOM PALLETS, JEFFERSON INSURANCE COMPANY OF NEW YORK, ALLIANZ LIFE INSURANCE COMPANY OF NEW YORK, INTERNATIONAL REINSURANCE COMPANY, S.A., LIFE USA, AGF AMERIQUE, AGF HOSPITALIERS, AGF ASSET MANAGEMENT, FIREMAN'S FUND INSURANCE COMPANY, THE NORTHERN TRUST COMPANY AS TRUSTEE OF THE FIREMAN'S FUND INSURANCE COMPANY MASTER RETIREMENT TRUST AND AS TRUSTEE OF THE FIREMAN'S FUND INSURANCE COMPANY MASTER RETIREMENT SAVINGS TRUST, ALLIANZ INSURANCE COMPANY, ALLIANZ LIFE INSURANCE COMPANY OF NORTH AMERICA, ALLIANZ ASSET MANAGEMENT NORTH AMERICAN EQUITY, US ALLIANZ DIVERSIFIED ANNUITY, US ALLIANZ GROWTH ANNUITY, US ALLIANZ VARIABLE INSURANCE PRODUCTS TRUST, AZOA GROWTH FUND, AZOA DIVERSIFIED ASSETS FUND, ALLIANZ OF AMERICA, INC., ALLIANZ CORNHILL INSURANCE PLC, CORNHILL PENSION NORTH AMERICAN EQUITY FUND, CORNHILL LIFE INSURANCE, MERCHANT INVESTORS ASSURANCE COMPANY LIMITED, AND CORNHILL LIFE NORTH AMERICAN EQUITY FUND, PLAINTIFFS-APPELLANTS,
v.
WINSTAR COMMUNICATIONS, INC., WILLIAM J. ROUHANA, JR., RICHARD J. UHL, NATHAN KANTOR, ROBERT K. MCGUIRE, DEFENDANTS, AND GRANT THORNTON LLP, DEFENDANT-APPELLEE.*FN1



The opinion of the court was delivered by: Lohier, Circuit Judge:

10-4028-cv(L), 10-4280-cv(CON)

BIM Intermobiliare SGR v. Grant Thornton LLP

Argued: November 2, 2011

Before: SACK, HALL, and LOHIER, Circuit Judges.

8 Plaintiffs-Appellants appeal from a judgment of the United States District Court for the 9 Southern District of New York (Daniels, J.) granting the motion for summary judgment of 10 Defendant-Appellee Grant Thornton LLP ("GT") and dismissing the Plaintiffs' claims under 11 Sections 10(b) and 18 of the Securities Exchange Act of 1934. Those claims related to GT's 12 auditing of the financial statements of Winstar Communications, Inc. ("Winstar"). Because 13 triable questions of fact exist as to (1) whether GT acted with scienter in making alleged 14 misrepresentations in its audit opinion letter, (2) whether the Plaintiffs purchased Winstar's stock 15 in actual reliance on those representations, and (3) whether the Plaintiffs suffered losses as a 16 result, we VACATE the judgment of the District Court and REMAND for further proceedings.

17 Plaintiffs-Appellants appeal from a September 2010 judgment of the United States 18 District Court for the Southern District of New York (Daniels, J.) granting the summary 19 judgment motion of Defendant-Appellee Grant Thornton LLP ("GT") and dismissing the 20 Plaintiffs' claims arising from GT's audit of the financial statements of its client, Winstar 21 Communications, Inc. ("Winstar"). The Plaintiffs claimed that GT committed securities fraud in 22 violation of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (the "Act" 23 or the "Exchange Act"), and 17 C.F.R. § 240.10b-5, and made false and misleading statements in 24 an audit opinion letter in violation of Section 18 of the Act, 15 U.S.C. § 78r. We conclude that 25 genuine issues of material fact exist as to each of these claims. We therefore VACATE the 26 District Court's grant of summary judgment and REMAND for further proceedings.

1 BACKGROUND

1. Facts

3 Reviewing the District Court's grant of summary judgment in favor of GT, "we construe 4 the evidence in the light most favorable to the [Plaintiffs], drawing all reasonable inferences and 5 resolving all ambiguities in [their] favor."*fn2 In re Omnicom Grp., Inc. Sec. Litig., 597 F.3d 501, 6 504 (2d Cir. 2010) (quotation marks omitted).

7 Winstar was a broadband communications company whose core business was to provide 8 wireless Internet connectivity to various businesses. GT served as Winstar's independent auditor 9 from 1994 until Winstar filed for bankruptcy in April 2001, and GT regarded Winstar as "one of 10 [its] largest and most important clients."*fn3

11 In 1999, however, the relationship deteriorated. Winstar warned GT that it would likely 12 terminate the relationship if GT's performance on unrelated international tax planning and other 13 accounting matters proved unsatisfactory. In March 1999 at least one member of Winstar's 14 board of directors openly urged during a board meeting that the GT partner overseeing the audit 15 of Winstar be removed from the Winstar account. GT eventually re-staffed the Winstar account 16 so that the 1999 audit was managed by a partner, Gary Goldman, and a senior manager, Patricia 1 Cummings, neither of whom had previously reviewed or audited the financial records of a 2 telecommunications company.

3 As relevant to this appeal, GT's audit for 1999 included several "large account" 4 transactions that Winstar consummated in an attempt to conceal a decrease in revenue associated 5 with Winstar's core business. Most of the large account transactions involved Lucent 6 Technologies, Inc. ("Lucent"), Winstar's strategic partner, and all of them were consummated at 7 the end of Winstar's fiscal quarters in 1999. Together, the transactions accounted for $114.5 8 million in revenue, or approximately 26 percent of Winstar's reported 1999 operating revenues 9 and 32 percent of its "core" revenues that year. At the time, GT considered these transactions to 10 be "red flags," warranting the accounting firm's "heightened scrutiny."*fn4 However, GT 11 ultimately approved Winstar's recognition of revenue in connection with each of these 12 transactions.

13 We discuss the evidence relating to each category of transaction in turn.

14 A. Questionable Sales

15 The first category of questionable transactions involved a series of six end-of-quarter and 16 end-of-year transactions, primarily reported as equipment sales, for which there was little 17 evidence that any goods or services were ordered and delivered. For example, for the third 18 quarter of 1999 Winstar recognized $15 million in revenue for the sale of Lucent equipment to 19 Anixter Brothers, Inc. ("Anixter"), a wire and cable distributor. There were several unusual 1 aspects of this sale. First, Anixter ordinarily purchased equipment directly from Lucent, not 2 Winstar. Second, equipment sales were not part of Winstar's core business of creating and 3 operating wireless networks. Third, during GT's audit Cummings noted that the Anixter 4 transaction was "apparently" completed on September 30, 1999, the last day of Winstar's fiscal 5 quarter, but GT's work papers included no documents reflecting the sale's completion beyond a 6 purchase order from Winstar to Lucent and an invoice from Lucent to Winstar. Moreover, 7 neither the purchase order nor the invoice included an itemized list of the goods sold or indicated 8 the shipping terms, even though the items were to be shipped on September 30, 1999, and 9 delivered on October 4, 1999.*fn5 Absent too was any document evidencing Anixter's agreement to 10 purchase the items. Lastly, not a single employee of Lucent, Winstar, or Anixter who was asked 11 about the equipment sale could recall it.

12 Five other transactions that were not part of Winstar's core business were consummated 13 at the end of one of Winstar's fiscal quarters and were barely documented. Winstar nevertheless 14 recognized a total of $49.7 million in revenue associated with these five transactions. First, 15 Winstar recognized $5 million in revenue in the first quarter of 1999 for a "feasibility study" that 16 Winstar was scheduled to conduct for Lucent, but which had not been delivered by at least 2000. 17 Second, Winstar recognized $21.1 million in revenue in the first and second quarters of 1999 in 1 connection with the sale of Lucent equipment to Williams Communications, Inc. ("Williams").

2 The equipment was shipped by Lucent, not Winstar, on the last business day of the first and 3 second quarters (March 31, 1999 and June 30, 1999, respectively), with no written agreement. 4 Third, Winstar recognized $9.1 million in revenue in the second quarter of 1999 in connection 5 with the sale of Lucent equipment to VoCall Communications Corporation ("VoCall") on June 6 30, 1999. Although the sale was referenced in a series of non-numbered purchase orders, it was 7 not referenced in any executed, final agreement or shipping document. Fourth, Winstar 8 recognized $4.5 million in revenue in the third quarter of 1999 in connection with the sale of 9 unspecified "WinStar Equipment" to Cignal Global Communications ("Cignal"), which was 10 contracted for on September 30, 1999, the last day of that quarter. However, GT was unable to 11 produce a document evidencing that the equipment had been shipped to Cignal during that 12 quarter. Fifth, Winstar recognized $10 million in revenue in the fourth quarter of 1999 in 13 connection with the sale of wireless radio equipment ("radios") to Lucent under an agreement 14 dated December 30, 1999. GT endorsed the recognition of revenue even though its work papers 15 included shipping documents with conflicting dates, no document specified the goods purchased, 16 and Lucent, not Winstar, was in the business of manufacturing and selling radios. The same 17 agreement also involved a $2 million "promotional credit" purchased by Lucent for services that 18 had not yet been rendered by Winstar. Although GT specifically advised Winstar that 19 recognizing and recording the amount of the credit as revenue was improper and in violation of 1 generally accepted accounting principles ("GAAP"),*fn6 Winstar nevertheless recognized the full 2 $2 million in revenue.

3 Each of these transactions appears to have violated the provisions of Staff Accounting 4 Bulletin No. 101 ("SAB 101"), issued by the Securities and Exchange Commission ("SEC"), 5 which states that four conditions must be satisfied before revenue can be recognized: (1) 6 "Persuasive evidence of an arrangement [for the sale of goods or services] exists," (2) "Delivery 7 has occurred or services have been rendered," (3) "The seller's price to the buyer is fixed or 8 determinable," and (4) "Collectibility is reasonably assured." SAB 101 at 3.*fn7

1 GT requested that Winstar's counterparties provide additional documentary evidence of 2 the relevant sales underlying each questionable transaction. By doing so, consistent with SAB 3 101, GT sought to obtain independent support for Winstar's recognition of revenue for each 4 transaction - in other words, support from documents that were not generated by Winstar itself.

5 As of February 10, 2000, GT still had not received responsive documents from four of these 6 customers. Nonetheless, it issued an audit opinion letter opining that Winstar's 1999 financial 7 statements accurately reflected its financial condition and complied with GAAP.

8 B. Bifurcated Accounting

9 In connection with at least three other transactions, Winstar employed a bifurcated 10 accounting scheme that GT ultimately approved prior to its audit of Winstar's financial 11 statements. Two of these transactions involved leasing or subleasing fiber optic network 12 capacity in units called indefeasible rights of use ("IRUs"). Winstar accounted for these IRUs 13 using a dubious bifurcated accounting method, pursuant to which it recognized as much as 94 14 percent of the revenue from the leases upon execution of ...


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