The opinion of the court was delivered by: Whyte, U.S. District Judge.
ORDER RE MOTIONS TO DISMISS
Pending before the court are fourteen motions to dismiss the complaint
pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, which
were heard by the court on September 15, 2000. The court has read the
moving and responding papers and heard the argument of counsel. The
court's ruling is set forth in full at the end of this order.
This is a securities class action lawsuit stemming from a dramatic
decrease in the trading price of McKesson HBOC, Inc. ("McKesson HBOC")
stock in April 1999.
A. INFORMATION PUBLICLY AVAILABLE BEFORE THE FILING OF THE COMPLAINT
In October 1998, McKesson, Inc., a San Francisco-based company,
announced that it would be acquiring HBO & Company ("HBOC"), a healthcare
software company based in Atlanta, Georgia, through a merger.*fn1 The
newly formed entity was to be named McKesson HBOC, Inc. On November 13,
1998, McKesson registered shares for McKesson HBOC, Inc. with the
Securities Exchange Commission ("SEC"). These shares were to be issued to
HBOC shareholders in the event that the merger was approved. As part of
the registration process, McKesson filed a registration statement ("the
Registration Statement"). The McKesson November Registration Statement
included, among other things, data from HBOC's financial statements (some
of which had been previously filed by HBOC with the SEC). The McKesson
November Registration Statement also disclosed that holders of HBOC
common stock would receive 0.37 shares of newly-issued McKesson HBOC
stock for each share of HBOC stock.
The acquisition of HBOC required approval from the shareholders of both
companies. On November 27, 1998, the two companies solicited proxies
through a joint proxy statement and prospectus ("the Joint Prospectus").
The Joint Prospectus contained the same HBOC financial data reported in
the McKesson November Registration Statement.
Both companies' shareholders approved the merger, which was
accomplished on January 12, 1999. That same day, McKesson was renamed
McKesson HBOC, Inc. HBOC became McKesson HBOC's Healthcare Information
Technology Business Unit ("the ITBU"), a wholly owned subsidiary of
McKesson HBOC. On the day of the merger, McKesson HBOC stock traded for
as much as $89 1/2 per share.
Barely four months later, on April 27, 1999, McKesson HBOC issued a
press release in which it announced the company's discovery of more than
$42 million in improperly recognized revenue, which would have to be
reversed. The improperly recognized sales were in fact contingent
transactions. The improperly recognized sales all came from HBOC and the
ITBU. The company warned that it was continuing a financial audit, and
warned of the "possibility that additional contingent sales may be
identified." (Compl. ¶ 41.)
The market reacted swiftly to this disclosure. Within 24 hours, the
trading price of McKesson HBOC stock had dropped from the previous day's
close of $65.75 to a closing price of $34.50. This drop represented a $9
billion drop in market capitalization.
On May 25, 1999, McKesson HBOC issued a further press release, which
updated the market on the status of the HBOC/ ITBU audit. According to the
press release, "additional instances of improper revenue recognition have
been found." (Compl. ¶ 43.) The press release promised that the
company would conclude the investigation and issue corrected financials
in the near future.
Less than a month later, and before it had issued corrected
financials, the company announced that several former HBOC executives
were being terminated for their participation in the HBOC/ITBU accounting
improprieties. Specifically, the company announced that McKesson HBOC
Chairman Charles W. McCall "has been removed as Chairman of the Board and
dismissed as an employee" and that four other ITBU officers —
including defendants Bergonzi, Lapine and Smeraski — had "been
dismissed immediately for cause." (Compl. ¶ 170a.) In subsequent
communications with the press, McKesson HBOC officials (including the
company's newly appointed Chairman and its official spokesperson)
discussed the ongoing HBOC/ ITBU audit. According to these officials,
HBOC/ITBU senior management had been intentionally (and secretively)
booking contingent software transactions as sales for several years.
(Compl. ¶¶ 170b-f.)
Finally, on July 14, 1999, McKesson HBOC issued a press release
announcing the results of its audit. The audit had uncovered more than
$327 million in improperly recorded transactions, of which at least $50
million were never likely to become properly recognizable sales. (Id.
¶ 45.) The company's restated financials were filed with the SEC on
July 16, 1999.
Not surprisingly, several dozen shareholders' lawsuits had meanwhile
been filed. Named defendants included McKesson HBOC, the ITBU, directors
and executives of the corporations involved in the merger, and the
accounting firm and investment bank that failed to undercover the alleged
The various class actions alleging violations of federal securities law
have been consolidated in this court, and the New, York State Common
Retirement Fund has been appointed Lead Plaintiff for those actions.
On February 25, 2000, Lead Plaintiff filed an Amended and Consolidated
Class Action Complaint ("the Complaint"). The Complaint alleges sixteen
causes of actions against almost all possible defendants (with the
notable exception of HBOC /ITBU, which has been sued by Lead Plaintiff in
a separate complaint). The Complaint provides the specifics of the
restated financial data and also details McKesson HBOC's public
statements about the accounting improprieties.
B. INVESTIGATIVE FINDINGS SUMMARIZED IN THE AMENDED AND CONSOLIDATED CLASS
In addition, the Complaint summarizes the results of lead counsel's
investigation into the HBOC/ITBU accounting irregularities, as well as
investigative reporting in the Wall Street Journal about the alleged
1. Lead Counsel's Investigation
The Complaint identifies 15 HBOC employees and customers who cooperated
with lead counsel's investigation. They are identified by job title, but
not by name.
The sources implicate several of the named defendants in HBOC's
apparently widespread practice of accompanying contracts with side letters
that revealed contingencies not disclosed on the face of the contract.
(Compl. ¶ 181-182.) The sources state that the side letters were
often stored separately from the contracts. The complaint recounts
several witnesses' statements implicating several defendants in the
improper recognition of those contingent sales as revenue. According to
the relevant section of the complaint:
183. Independent sources told plaintiffs'
investigators that while defendant Gilbertson had the
final say as to whether and when revenue would be
recognized on a given contract, including those that
were subject to contingencies and "side letters," or
knew of the decision, such decisions were
collaborative efforts among defendants McCall,
Bergonzi, Gilbertson and Lapine.
a. A Senior Vice President ("Sr. V.P.1"), a Regional
Vice President who came to HBOC when it merged with
AMYSIS, and a former sales representative ("Sales
Rep. 2") confirmed that ultimate responsibility for
recognizing revenue lay with defendant Gilbertson,
but that decisions were made in collaboration with
defendant Bergonzi and others, including DeRosa and
Glen Rosenkoetter, an assistant Vice President. This
collaboration was confirmed by another Senior Vice
President ("Sr.V.P.2") and Regional V.P. 3.
According to Sales Rep. 2, defendant Gilbertson
stated that he had final authority on revenue
recognition in conference calls with Sales Rep. 2
and the Regional Vice President regarding a large
contract they were negotiating, which contained
b. Sales V.P. 1, Regional V.P. 1 and Sr. V.P. 2
identified defendants McCall, Bergonzi and
Gilbertson as being involved in making decisions on
whether to book revenue from particular
transactions. Sales V.P. 1 said it was common
knowledge among HBOC salesmen and management that
both McCall and Bergonzi knew of and actively
encouraged the posting of contingent, consignment
and even purely fictitious sales as current
revenue. According to this individual, McCall and
Bergonzi made the decisions to book revenue on
contingent transactions, including sales with "board
approval amendment" contingencies (i.e., proposed
deals which required, but had not yet received,
approval of the purchaser's board of directors).
c. Sales V.P. 2 was personally involved in
negotiating the detailed terms of numerous major
contracts and was in a position to know the precise
status of such contract negotiations. According to
Sales V.P. No. 2, and based on his firsthand
knowledge, Bergonzi, Gilbertson and Lapine, as well
as Dominick DeRosa, former HBOC National Sales
Director, knew that HBOC was booking contingent
sales as immediate revenue, and Bergonzi
participated in the decisions to book revenue on
d. Contracts were kept outside of normal channels,
for among other reasons, to avoid having to pay
commissions to sales representatives and vice
presidents. According to a former HBOC product
manager ("Product Manager") and a former HBOC
regional sales vice president ("Regional V.P. 3"),
decisions as to whether to recognize revenue and
whether to pay commissions on particular contracts
were made by, among others, defendants Bergonzi and
e. According to Sales V.P. 2, many of HBOC's major
sales contracts were contingent in nature and
provided for delivery of the products supposedly
"sold" over periods as long as two years. Thus, for
example, HBOC booked revenues on deals with Quorum
in 1994 (a deal in which Sales V.P. 2 was actively
involved) and with Beverly Enterprises in 1997 (a
deal handled by another Vice President of Sales),
despite the wholly contingent nature of these
"sales." Bergonzi, Gilbertson and DeRosa decided to
book revenue in the Quorum deal at a time when the
contract was months away from being signed.
f. According to Sales V.P. 1., Bergonzi also
personally negotiated on HBOC's behalf with the
Chief Information Officer of Baptist Hospital,
Memphis, Tennessee. This contract for an Enterprise
Solutions System was signed on December 31, 1997.
HBOC booked current revenue in 1997 from the deal
negotiated by Bergonzi, even though the contract did
not provide for immediate delivery of any product,
but rather contemplated an ongoing production of
systems and support services over more than one
year. Indeed, some of the software supposedly sold
to Baptist Hospital was never installed by HBOC.
184. Notwithstanding the fact that certain employees
objected to the revenue recognition practices at HBOC,
defendants continued to improperly recognize revenue.
a. According to Sales V.P. 1, after DeRosa left HBOC
in the Fall of 1998 and was replaced by defendant
Smeraski, McCall and Bergonzi personally thwarted an
attempt by Smeraski to "bring some sanity into what
they were selling or not selling." i.e., to ensure
that only truly final sales were reported as
generating sales revenue. Shortly after replacing
DeRosa, Smeraski learned of the improper accounting
underlying HBOC's reported sales revenues, and told
the sales force, including Sales V.P. 1, that the
sales numbers reported by HBOC were "not real." He
further told the HBOC sales force, including Sales
V.P. 1, that they would not be able to "make their
numbers," i.e., their sales quotas, because he would
not condone the continuation of the improper sales
practices (e.g., the creation of secret side
letters, the backdating of contracts, etc.) needed
to support the accounting fraud. Shortly
thereafter, however, McCall, Bergonzi and Gilbertson
forced Smeraski to permit these improper practices
to continue and directed him to make sure that the
sales force continued to "make their numbers."
Rather than resign his position, or even expose
these improprieties., Smeraski willfully acceded to
and actively participated in HBOC's wrongful
b. In January and February 1999, after the close of
the fourth quarter of 1998, Area V.P. learned that
revenues had been booked from several contracts that
he personally knew contained unsatisfied
contingencies, which Area V.P. believed would
ultimately fail to be satisfied. These included the
St. Vincent's Infirmary in Little Rock, Arkansas and
Riverside Hospital in Wichita, Kansas, contracts
discussed below. He recommended to defendants
Bergonzi and Smeraski that these deals be "debooked"
because of the probability that the contingencies
would not be satisfied. These recommendations were
2. The Wall Street Journal Article
On July 15, 1999, the Wall Street Journal published a lengthy article
detailing its own investigation of the financial irregularities at HBOC.
The portions excerpted in the complaint state:
In one case, a former HBO salesman says, his managers
shipped and booked a $200,000 software upgrade even
though his customer, a Los Angeles hospital, had
merely agreed to consider buying it later. Others say
that HBO executives sometimes enconraged salespeople
to backdate contracts by up to a week so as to include
the sale in a quarter that had just ended. A person
close to the investigation doesn't dispute this
Deloitte [& Touche, the Company's outside auditors,]
staffers had taken the routine step of sending letters
to HBO customers to verify that contracts were as
recorded. A junior auditor was surprised to hear back
from a computer customer that its $20 million software
purchase hadn't, in fact, gone through and had been
backdated. Soon, several smaller contracts turned out
to be contingent on unmet conditions.
[The McKesson HBOC audit committee] formed a review
team including lawyers from Skadden, Arps, Slate,
Meagher & Flom and dozens of forensic accountants from
PricewaterhouseCoopers, skilled at reconstructing
computer records. The committee told the team to do a
second audit, independent of Deloitte, and meet with
Justice Department and SEC officials.
As the team grilled 36 HBO staffers, they turned up
more and more cases of contracts that included "side
letters" stating conditions that had to be met for
sales to go through. The letters were stashed away in
various places, but always kept separate from the
contract files presented to outsiders. They cited
contingencies ranging from board approval to the
arrangement of financing.
[S]oon the review team uncovered explosive new
evidence, people close to the inquiry say. They
managed to access hard-disk files previously deleted.
These "dark files," as investigators call them,
provided clues, including schedules, memos, codes
— and the secret list of contracts with
references to contingencies that hadn't been met. They
also helped identify backdated contracts.
After further interviews at HBO headquarters in
Atlanta, the team concluded that at least four HBO
officials had participated in an organized approach to
accelerating the recognition of revenue, says someone
close to the inquiry.
In one case, a Southern California hospital had all
but signed off on a big purchase from HBO when a large
chain agreed to acquire the institution. That scotched
the deal, says the former HBO salesman on the
account. HBO booked it anyway, he says, adding, "I
told them the deal wasn't going to close. They told
me, `We're still going to ship.' That's how they
booked revenue and invoiced the sale." A person close
to the investigation calls this account consistent
with its findings.
In software accounting, a signed contract often
doesn't amount to a sale. The goods must leave the
company's shipping dock. "It was common knowledge that
if you thought you would get the order, and it was
close to end of quarter, then you'd tell them to ship
the software," says Richard Varlyan, a former HBO
salesman in Canada. "All they wanted was a receipt
from the hospital that it arrived." Making this
booking of sales even dicier was the fact that this
complex software is essentially useless until an HBO
technician has laboriously installed it.
One Los Angeles hospital agreed to sign a contingent
contract in July 1997. But its chief information
officer, or CIO, says he had no intention of buying
the product. The side letter stated that he had no
obligation; it merely committed HBO to sell the
product at a set price for up to a year. Yet a year
later, a boxload of the software landed in the CIO's
"We called them up and said, `Hey, we didn't buy
this. Don't bill us,'" the CIO says. The salesman
reappeared and tried to get him to extend the deal for
another year, the CIO says. "I said, `No way.'"
Such a pattern came quickly into focus after the
"dark files" discovery.
McKesson's audit committee took its findings to the
full board on June 18 [, 1999], with recommendations
to retain or not retain certain people. The board
formed a committee of outside directors to consider
the proposal, and it decided on the dismissals.
Rule 8(a) of the Federal Rules of Civil Procedure requires only "a
short and plain statement of the claim showing that the pleader is
entitled to relief." As a result, motions to dismiss for failure to state
a claim pursuant to Rule 12(b)(6) are typically disfavored; complaints
are construed liberally to set forth some basis for relief, as long as
they provide basic notice to the defendants of the charges against them.
While the Rule 8 notice pleading standard is the general rule, the more
specific provisions of Rule 9(b) apply to "all averments of fraud or
mistake." In such cases, "the circumstances constituting fraud or mistake
shall be stated with particularity." Fed.R.Civ.P. 9(b). This requires
pleading of two types of information: (1) the "time, place, and content of
alleged misrepresentation" (the "neutral facts necessary to identify the
transaction"); and (2) "an explanation as to why the statement or
omission complained of was false or misleading." In re GlenFed, Inc.
Sec. Litig., 42 F.3d 1541, 1547-48 (9th Cir. 1994) (en banc).
The Private Securities Litigation Reform Act of 1995 ("PSLRA" or "the
Reform Act") tightens these requirements even further for securities
fraud allegations. Most importantly, the Reform Act requires
particularized pleading of scienter: "the complaint shall, with respect to
each act or omission alleged to violate this chapter, state with
particularity facts giving rise to a strong inference that the defendant
acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2)(a).
The Ninth Circuit recently interpreted this statutory provision in In re
Silicon Graphics Inc. Securities Litigation, 183 F.3d 970 (9th Cir.
1999). The Silicon Graphics court held that "a private securities
plaintiff proceeding under the PSLRA must plead, in great detail, facts
that constitute strong circumstantial evidence of deliberately reckless
or conscious misconduct. . . . [Averment of particular facts giving rise
to a strong inference of deliberate recklessness, at a minimum, is
required to satisfy the heightened pleading standard under the PSLRA]."
183 F.3d at 974. A "strong inference" is to be distinguished from "a mere
speculative inference . . . or even a reasonable inference." Id. at 985.
Section 11 of the Securities Act of 1933 creates civil liabilities for
persons who issue registered securities pursuant to false registration
statements. Section 11 provides:
In case 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, any person acquiring such security (unless
it is proved that at the time of such acquisition he
knew of such untruth or omission) may, either at law
or in equity, in any court of competent jurisdiction,
(1) every person who signed the registration
(2) every person who was a director of (or person
performing similar functions) or partner in the issuer
at the time of the filing of the part of the
registration statement with respect to which his
liability is asserted;
(3) every person who, with his consent, is named in
the registration statement as being or about to become
a director, person performing similar functions, or
(4) every accountant, engineer, or appraiser, or any
person whose profession gives authority to a statement
made by him, who has with his consent been named as
having prepared or certified any part of the
registration statement, or as having prepared or
certified any report or valuation which is used in
connection with the registration statement, with
respect to the statement in such registration
statement, report, or valuation, which purports to
have been prepared or certified by him;
(5) every underwriter with respect to such security.
15 U.S.C. § 77k(a). Culpable conduct is not an element of a Section
11 claim. See Herman & MacLean v. Huddleston, 459 U.S. 375, 382, 103
S.Ct. 683, 74 L.Ed.2d 548(1983). However, the statute provides a number
of affirmative defenses for defendants (other than the issuer), including
reasonable reliance on expert or governmental reports and lack of damages
to plaintiffs. See 15 U.S.C. § 77k(b), (c), (e).
Lead Plaintiff has filed Section 11 claims against virtually every
corporate and individual defendant. The Section 11 allegations can be
divided into two basic groups:
(1) claims based on McKesson's republication of HBOC's
false financial data in the November Registration
Statement, brought by those HBOC shareholders who were
issued McKesson HBOC, Inc. stock pursuant to the
November Registration Statement during the merger
("the HBOC shareholders"); and
(2) claims based on HBOC's publication of false
financial data in a series of registration statements
for HBOC stock issued in exchange for stock of several
companies acquired by HBOC before it was itself
acquired by McKesson, brought by shareholders of the
acquired companies ("the early exchangers").
Defendants move to dismiss both sets of allegations.
1. The Former HBOC Shareholders and the November Registration Statement