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IN RE MCKESSON HBOC

September 28, 2000

IN RE MCKESSON HBOC, INC. SECURITIES LITIGATION


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.

I. BACKGROUND

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 McKesson November 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 accounting fraud.

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 COMPLAINT

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 accounting fraud.

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 contingencies.
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 contingent transactions.
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 Gilbertson.
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 accounting practices.
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 ignored.

(Compl. ¶¶ 183-184.)

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 account.
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 office.
"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.

(Compl. ¶ 177.)

II. LEGAL STANDARD

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.

III. ANALYSIS

A. SECTION 11 CLAIMS

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, sue —
(1) every person who signed the registration statement;
(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 partner;
(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

Defendants argue that the former HBOC shareholders fail to state a claim with regard to McKesson's financial statement because the false HBOC financial data in the November Registration Statement was immaterial to HBOC shareholders in deciding whether to purchase McKesson stock. Defendants also argue that the complaint reveals a lack of damages suffered by former HBOC shareholders. Certain Section 11 defendants also allege that the claims are insufficiently particular and that the complaint pleads facts showing that they are entitled to an affirmative defense of expert reliance. For its part, Arthur Andersen argues that it should be dismissed as a Section 11 defendant because the April corrective disclosure did not reveal any improprieties relating to Arthur Andersen's ...


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