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IN RE PORTAL SOFTWARE

August 10, 2005.

IN RE PORTAL SOFTWARE, INC SECURITIES LITIGATION.


The opinion of the court was delivered by: VAUGHN WALKER, District Judge

ORDER

Plaintiffs in this securities fraud class action face the unenviable task of complying with the stringent pleading requirements imposed on such actions. All too frequently, and once again here, plaintiffs attempt this endeavor by a complaint replete with evidentiary detail, but only a loose (and the court thinks too loose) connection between the wrongful conduct alleged and its effect on the class. The Supreme Court has recently reminded lower federal courts that the heart of a fraud on a securities market is the proximate causal link between the misstatement or omission alleged and the resulting impact on the security's price. Dura Pharms Inc v. Broudo, 125 S Ct 1627 (2005). Despite the rather forgiving interpretation of Dura in this circuit, see In re Daou Systems, Inc Securities Litigation, 2005 WL 1431833 (9th Cir June 21, 2005), the operative pleading here fails to make this connection. Because plaintiffs will be allowed to amend, the court emphasizes the need for plaintiff to allege facts that link defendants' alleged wrongdoing to the class injury. A much shorter, but targeted, pleading may well be more effective in making this connection than the rather distended pleading now at bar. But there are other shortcomings in their pleadings that plaintiffs need to address and it is to these that the court devotes the bulk of this order.

I

  Plaintiff John Romeo (Romeo) and plaintiff Pipefitters Local 522 & 633 Pension Fund Trust (Pipefitters) (collectively, plaintiffs), purporting to represent investors who purchased securities of Portal Software Inc (Portal) between May 20, 2003, and November 13, 2003, inclusive (the "class period"), bring this action under the Securities Exchange Act of 1934 (the "`34 Act") and the Securities Act of 1933 (the "`33 Act"). Plaintiffs allege that defendants Portal, John Little (Little), Howard A Bain III (Bain) and Arthur C Patterson (Patterson) (collectively defendants) violated the Generally Accepted Accounting Principals (GAAP) by artificially inflating the price of Portal's stock and making false and misleading statements on which plaintiffs relied, thereby incurring substantial financial loss from purchasing Portal stock at fraudulently inflated prices. Defendants' move to dismiss (Doc #115) plaintiffs' third consolidated amended complaint (TCAC; Doc #111) for failure to meet the particularity requirement imposed by FRCP 9(b) and the Private Securities Litigation Reform Act (PSLRA) (amendments to the '33 and '34 Acts). Plaintiffs oppose the motion, asserting that the TCAC states sufficiently particularized claims under § 10(b) and § 20(a) of the '34 Act, as well as claims under §§ 11, 12(a)(2) and 15 of the '33 Act.

  The court heard argument on these motions on July 7, 2005. Based upon the parties' arguments and the applicable federal law, the court concludes that: (1) the allegations in plaintiffs' complaint are not pled with sufficient particularity under the PSLRA and FRCP 9(b); (2) the allegations are not sufficient to support a strong inference of scienter under the PSLRA; (3) defendants' forward-looking statements are protected by the PSLRA's safe harbor provision; (4) claims under the '33 Act sound in fraud and therefore fail with the '34 Act claims. Accordingly, the court GRANTS defendants' motion to dismiss in its entirety.

  II

  The factual and procedural history is derived from the TCAC and presumed true for purposes of this motion. Gompper v. VISX, Inc, 298 F3d 893, 895 (9th Cir 2002). Portal provides billing and subscriber management solutions to its clients primarily through its "Infranet" software. Portal charges companies "license fees" for the Infranet product, as well as "service fees" for system implementation, consulting, maintenance and training. Prior to 2001, the majority of Portal's customer base consisted of "dot-com" start-up companies. Following the dot-com market crash of 2001, Portal lost many of its customers and incurred financial losses during fiscal 2002-2003 that wiped out more than 96% of Portal's equity. Portal subsequently began to market its Infranet product to more established and sophisticated business customers, including telecommunications providers. These new clients required greater customization of the software than had the dot-com startups, which in turn affected the way in which Portal could recognize license fee revenues. Pursuant to GAAP, if a software provider rewrites portions of its product to conform to a client's unique needs, it may not fully recognize the revenue on the license of software until such substantial modification has been performed. Whereas Portal had historically been able to recognize revenue at the time it delivered its Infranet product to the dot-coms, the greater customization required by these new, more established clients required Portal to defer recognizing revenue from much of its contracts until customization was complete. Plaintiffs allege that during the class period, Portal began to manipulate its license fees so it could recognize more revenue "up-front." TCAC at ¶¶ 41-42.

  To support their allegations that Portal improperly recognized revenue prematurely and in violation of GAAP, plaintiffs rely on information from four unnamed former Portal employees: (1) a controller; (2) a "Senior Business Analyst'" (3) an accounts receivable and revenue assurance assistant; and (4) a "Senior Marketing Manager." TCAC at ¶¶ 41-54. The first three employees detail three different methods of accounting fraud allegedly undertaken by Portal management during the class period, while the Senior Marketing Manager alleges ongoing product problems and a decreasing market for key elements of Portal's software offering.

  The information provided by the former controller involved Portal's method for recognizing licensing revenue. Historically, Portal preliminarily offered its customers a "developmental license," which consisted of a trial version of the software for a few key employees. Portal would charge only a "nominal" amount for this first license. Then, if the client wished to obtain the full Infranet product, Portal would sell the client a "production license" and charge for the bulk of the contract. After fiscal 2004, plaintiffs allege that Portal simply charged a greater portion of the contract price under the developmental license, even though it was still only a trial version and significant modifications yet were to be performed under the production license. Plaintiffs also allege that Portal's outside accountants, Ernst & Young, disapproved of this new split license arrangement and reversed Portal's position, a determination which ultimately caused the shortfall in earnings and resulting stock price decline. TCAC at ¶ 43.

  Next, the former Senior Business Analyst asserts that he was instructed by company officials, including Bain, to falsify revenue recognition studies to justify premature recognition of revenue. Under GAAP, when a software contract provides for both licensing and services, such as software modification and implementation, the revenue from each element can only be recognized as it is performed, so long as the "fair value" of each element is determinable. If the fair value of each element is not determinable, than recognition of the entire contract must be deferred until all elements have been delivered, or until such time as the fair value of the remaining elements are determinable. The Senior Business Analyst avers that when attempting to discern the fair value of elements of a software arrangement, he was directed by the management to "reverse engineer" the study to reach predetermined results. This employee, who ceased employment several months before the end of the class period, alleges that he was instructed to falsify revenue recognition studies with regard to contracts performed in "Greece, Italy, Columbia [sic] and Spain," including a contract with "Columbia [sic] Mobile." TCAC at ¶ 48.

  The third former employee on whom Plaintiffs rely is an accounts receivable and revenue assurance assistant employed during the class period. She alleges that "revenues related to [Portal's] contracts with Onstar . . . [were] materially overstated during the third quarter of fiscal 2004." TCAC at ¶ 49. Specifically, the former employee alleges that Portal would recognize revenue from the support, maintenance and upgrade elements of the software contract, even though the work had not yet been performed. This employee asserts that she obtained this knowledge because one of her duties of employment was to reclassify the prematurely recognized revenue for future quarters. She claims that she talked to her manager about her concerns with the way Portal was classifying revenue, and was subsequently dismissed from her position. TCAC at ¶ 49.

  Finally, plaintiffs proffer the testimony of a Senior Marketing Manager to substantiate their allegations that Portal was misrepresenting the demand for its product and concealing significant technical problems with its applications. Specifically, the marketing employee stated that portions of Portal's billing software were being rendered obsolete by Customer Relationship Management (CRM) applications sold by vendors like SAP and Siebel. TCAC at ¶¶ 51-52. Moreover, Portal's Infranet product was having difficulty interfacing with these CRM applications, resulting in unexpected costs and delays for Portal. TCAC at ¶¶ 53-54. Plaintiffs allege that Portal's management failed to disclose these technical difficulties and the declining demand for Portal's product during the class period, thus concealing the true state of Portal's financial health.

  Plaintiffs' complaint alleges that the accounting fraud described above was undertaken by defendants to inflate Portal's reported revenue numbers, which were then used by defendants to create false and misleading statements regarding Portal's financial health and future business prospects. According to plaintiffs, these false and misleading statements artificially inflated Portal's stock price and allowed defendants to complete a $60 million secondary offering on September 12, 2003. Plaintiffs' claims for violations of the '33 Act are based on alleged false and misleading statements made in the registration statement and prospectus issued in connection with the secondary offering. TCAC at ¶¶ 142-165. Plaintiffs' claims for violations of the '34 Act are based on alleged false and misleading statements disseminated to the investing public via SEC filings and press releases. TCAC at ¶¶ 166-181.

  After the close of the market on November 13, 2003, defendants announced that — due to contract delays, revenue recognition deferrals and service execution issues — Portal expected net losses of $0.36 to $0.40 per share for the third quarter fiscal 2004. These losses were in contrast to the net profits of $0.04 per share that Portal had previously projected for the quarter. Subsequent to the November 11, 2003, announcement, the price of Portal's common shares plummeted 42% to $8.77 in after hours trading. TCAC at ¶ 75. Plaintiffs allege that this decline in Portal's stock price at the end of the class period was "a direct result of the nature and extent of [d]efendant's prior misrepresentations, omissions and fraudulent conduct concerning [Portal's] adverse business and financial conditions finally being revealed to investors and the market" and that plaintiffs "were damaged as a proximate result thereof." TCAC at ¶ 76.

  III

  As a preliminary matter, the court considers defendants' request for judicial notice (RJN, Doc #119) regarding certain documents attached to the declaration of Randolph Gaw in support of defendants' motion (Gaw Decl, Doc #116). Defendants contend that all the documents so attached are the proper subject of judicial notice pursuant to FRE 201.

  Exhibits N through U to the Gaw declaration are Form 4s filed with the SEC regarding the stock sales of the individual defendants and other corporate officers and directors, while exhibits A through H are the SEC filings of defendant Portal. Defendants contend that the court is authorized to take judicial notice of documents filed with the SEC. The court agrees that judicial notice of such documents is proper. See, e.g., Bryant v. Avado Brands, Inc, 187 F3d 1271, 1276 (11th Cir 1999); Allison v. Brooktree Corp, 999 F Supp 1342, 1352 n3 (SD Cal 1998). This conclusion is bolstered by the fact that courts are specifically authorized, in connection with a motion to dismiss a securities fraud complaint, to consider documents and filings described in the complaint under the incorporation by reference doctrine. See, e.g., Ronconi v. Larkin, 253 F3d 423, 427 (9th Cir 2001); In re Silicon Graphics Securities Litigation, 183 F3d 970, 986 (9th Cir 1999). Thus, the court takes notice of all the documents attached to the Gaw declaration that were filed with the SEC.

  Exhibits I through M are Portal press releases, which defendants claim contain "safe harbor" warnings regarding any forward-looking statements in the press releases. Judicial notice of these exhibits is proper because the court is required to consider "any cautionary statement accompanying [a] forward-looking statement, which [is] not subject to material dispute, cited by the defendant." 15 USC § 78u-5(e). In addition, the court may take judicial notice of information that was publicly available to reasonable investors at the time the defendant made the allegedly false statements. See In re The First Union Corp Securities Litigation, 128 F Supp 871, 883 (WD NC 2001). This is true of press releases, even if they were not explicitly referenced in the complaint. See Wietschner v. Monterey Pasta Co., 294 F Supp 2d 1102, 1108-09 (ND Cal 2003).

  Exhibit V to the Gaw declaration is the "Statement of Position 97-2 Software Revenue Recognition." This is an accounting statement issued by the American Institute of Certified Public Accountants. RJN Doc #19 at 4. Courts may take judicial notice of documents that are alleged in the complaint and whose authenticity no party questions, even when not attached to the complaint. See Branch v. Tunnell, 14 F3d 449, 454 (9th Cir 1994).

  Finally, at oral argument on July 7, 2005, plaintiffs submitted to the court three additional documents and requested that the court take judicial notice of them in considering this motion. Doc #130. These documents include (1) a Portal press release dated June 30, 2005; (2) Portal's Form 8-K filed with the SEC on June 27, 2005; and (3) Portal's Form 10-Q for the quarter ending October 31, 2004, filed with the SEC on April 25, 2005. Id. The court takes notice of these documents, which are all public filings capable of judicial notice.

  IV

  Standard of Review

  FRCP 12(b)(6) motions to dismiss essentially "test whether a cognizable claim has been pleaded in the complaint." Scheid v. Fanny Farmer Candy Shops, Inc, 859 F2d 434, 436 (6th Cir 1988). FRCP 8(a), which states that plaintiff's pleadings must contain "a short and plain statement of the claim showing that the pleader is entitled to relief," provides the standard for judging whether such a cognizable claim exists. Lee v. City of Los Angeles, 250 F3d 668, 679 (9th Cir 2001). This standard is a liberal one that does not require plaintiff to set forth all the factual details of his claim; rather, all that the standard requires is that plaintiff give defendant fair notice of the claim and the grounds for making that claim. Leatherman v. Tarrant County Narcotics Intell & Coord Unit, 507 US 163, 168 (1993) (citing Conley v. Gibson, 355 US 41, 47 (1957)). To this end, plaintiff's complaint should set forth "either direct or inferential allegations with respect to all the material elements of the claim". Wittstock v. Van Sile, Inc, 330 F3d 899, 902 (6th Cir 2003).

  Under Rule 12(b)(6), a complaint "should not be dismissed for failure to state a claim unless it appears beyond doubt that plaintiff can prove no set of facts in support of [her] claim which would entitle [her] to relief." Hughes v. Rowe, 449 US 5, 9 (1980) (citing Haines v. Kerner, 404 US 519, 520 (1972)); see also Conley, 355 US at 45-46. All material allegations in the complaint must be taken as true and construed in the light most favorable to plaintiff. See Silicon Graphics, 183 F3d at 980 n10. But "the court [is not] required to accept as true allegations that are merely conclusory, unwarranted deductions of fact, or unreasonable inferences." Sprewell v. Golden State Warriors, 266 F3d 979, 988 (9th Cir 2001) (citing Clegg v. Cult Awareness Network, 18 F3d 752, 754-55 (9th Cir 1994)).

  Review of a FRCP 12(b)(6) motion to dismiss is generally limited to the contents of the complaint, and the court may not consider other documents outside the pleadings. Arpin v. Santa Clara Valley Transportation Agency, 261 F3d 912, 925 (9th Cir 2001). The court may, however, consider documents attached to the complaint. Parks School of Business, Inc v. Symington, 51 F3d 1480, 1484 (9th Cir 1995). If a plaintiff fails to attach to the complaint the documents on which the complaint is based, a defendant may attach such documents to its motion to dismiss for the purpose of showing that the documents do not support plaintiff's claim. In re Autodesk, Inc Securties Litigation, 132 F Supp 2d 833, 837 (ND Cal 2000) (citing Branch v. Tunnel, 14 F3d 449, 454 (9th Cir 1994)). This permits the court to consider the full text of a document that the plaintiff's complaint only partially quotes. Autodesk, 132 F Supp 2d at 838 (citing In re Stac Electronics Securities Litigation, 89 F3d 1399, 1405 n4 (9th Cir 1996), cert denied, ...


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