Monday, December 24, 2012
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C.A. Revives Securities Fraud Class Action Against Manufacturer
Panel Says Allegations Against Verifone Met Heightened Pleading Requirements of Federal Statute
By JACKIE FUCHS, Staff Writer
A class action suit against a San Jose-based electronics manufacturer and two of its chief officers stated claims for securities fraud, the Ninth U.S. Circuit Court of Appeals ruled Friday.
Writing for a unanimous panel, Judge M. Margaret McKeown said that Judge Marilyn Hall Patel of the U.S. District Court for the Northern District of California erred when she dismissed investors’ complaint against Verifone Holdings, Inc.
While the Private Securities Litigation Reform Act sets a heightened standard for pleading claims, McKeown said, the Verifone investors met the standard because the inference that the defendants were deliberately reckless regarding the veracity of their financial reports was at least as compelling as any opposing inference.
Verifone designs, markets and services transaction automation systems, such as point-of-sale devices for electronic payments. In 2006, VeriFone acquired Lipman Electronic Engineering Ltd., an Israeli-based developer, manufacturer and seller of electronic payment systems and software, and began integrating the two companies.
High Expectations
VeriFone touted the merger as likely to increase its pro forma gross margin expectations from between 41 and 44 percent to 42-47 percent, even though in the five quarters prior to the merger its gross margins had never exceeded 45.6 percent and Lipman’s had just dropped to 41.9 percent after five years of declines.
In the three quarters following the merger—VeriFone’s first three of fiscal 2007—VeriFone reported gross margins of 47.1 percent, 48.1 percent, and 48.2 percent, respectively.
“It is undisputed that these reports were false,” McKeown said, creating “a strong inference of scienter” on the part of VeriFone and Douglas Bergeron, the company’s chief executive officer and former chairman of the board of directors, and Barry Zwarenstein, its former chief financial officer and executive vice president.
The plaintiffs alleged, among other things, that the defendants knew that the merger would put downward pressure on their margins and that “their representations of increasing gross margins of up to 48 percent … had no reasonable basis.”
In each of the first three quarters of 2007, VeriFone’s initial internal financial reports, known as “flash” reports, showed the company’s gross margins at approximately 40–42 percent, far off the company’s projections and market expectations and a far more a drastic difference from initial projections than the company’s flash reports in prior years.
Manipulations Alleged
The plaintiffs alleged that in response to the disparity, Bergeron and Zwarenstein directed company management to “figure . . . it out” and “fix the problem,” by focusing on accounting decisions rather than operations, and suggested adjustments to VeriFone’s supply chain controller, Paul Periolat, including double-counting and inflating inventory.
Such “manipulations were deliberate and pervasive and done for the specific purpose of meeting public guidance” and were made possible by VeriFone’s lack of appropriate internal controls, the complaint alleged, adding that Zwarenstein and Bergeron knew in each quarter that the adjustments were “unusually high” and that they “recklessly failed to question or demand supporting documentation” for them.
The irregularities came to light in November 2007 when VeriFone’s auditors, Ernst & Young, audited the company and Periolat “was unable to explain his adjustments,” the plaintiffs alleged.
In early December 2007, VeriFone publicly announced that its consolidated financial statements for the first three quarters of that year should not be relied upon due to errors in accounting related to the valuation of in-transit inventory and allocation of manufacturing and distribution overhead to inventory.
The restatement of the company’s financial results resulted in reductions to net revenue of approximately $7.7 million, $11.5 million, and $8.4 million in the three respective quarters which, in turn, resulted in cumulative reductions in operating income from $65.6 million to $28.6 million, reflecting an overstatement of 129 percent.
Gross margins were accordingly reduced from 47.1 percent, 48.1 percent, and 48.2 percent to 41.4 percent, 42.3 percent, and 41.2 percent.
Overstated Earning
According to the complaint, VeriFone overstated earnings per share for the quarters at issue by 600 percent, 200 percent, and 418 percent.
On the day of the restatement, VeriFone shares dropped over 45 percent, falling from $48.03 to $26.03, and the following day the first of nine securities fraud class actions—which were eventually consolidated—was filed in the district court.
Patel concluded that the plaintiffs’ allegations failed to raise a strong inference of scienter on the part of any of the defendants and granted the motion to dismiss with prejudice.
But McKeown said the pleading met the standard established by Matrixx Initiatives, Inc. v. Siracusano (2011) 131 S. Ct. 1309, which explained the relevant inquiry as:
“[W]hether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.”
Books and Records
Of an SEC complaint charging VeriFone and Periolat with books and records violations—which was incorporated into the plaintiffs’ complaint—McKeown similarly said:
“It may well be the case that, as the district court concluded, the complaint does not establish or create a strong inference that anyone at VeriFone, including Periolat, actually knew that the manual adjustments were improper. However, that was not the only permissible inference. Recklessly turning a “blind eye” to impropriety is equally culpable conduct...”
She concluded:
“[The plaintiffs’] allegations, viewed holistically, give rise to a strong inference that Bergeron, Zwarenstein and VeriFone were deliberately reckless to the truth or falsity of their statements regarding VeriFone’s financial results, particularly gross margin percentages. This inference is cogent and equally as compelling as the competing inference that VeriFone ‘was simply overwhelmed with integrating a large new division into its existing business.’”
Judges Sidney R. Thomas and William A. Fletcher concurred in the opinion.
The case is In Re Verifone Holdings, Inc., 11-15860.
Copyright 2012, Metropolitan News Company