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Hong v. Extreme Networks, Inc.

United States District Court, N.D. California, San Jose Division

April 27, 2017

JUI-YANG HONG, et al., Plaintiffs,
v.
EXTREME NETWORKS, INC., et al., Defendants.

          ORDER GRANTING DEFENDANTS' MOTION TO DISMISS WITH LEAVE TO AMEND [Re: ECF 89]

          BETH LAB SON FREEMAN United States District Judge.

         This case arises from allegations that certain officers of Extreme Networks, Inc. engaged in securities fraud. Plaintiffs bring this action against Charles W. Berger, Kenneth B. Arola, and John T. Kurtzweil (collectively, “Individual Defendants”), and Extreme Networks, Inc. (collectively with the Individual Defendants, “Defendants”) under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5. Plaintiffs also assert claims against the Individual Defendants as “control persons” pursuant to Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a).

         Before the Court is Defendants' motion to dismiss. Mot., ECF 89. The Court heard oral argument on February 9, 2017. For the reasons set forth herein, the motion to dismiss is GRANTED WITH LEAVE TO AMEND. Defendants have also filed a request for judicial notice, which the Court GRANTS. Mot. 4 n.1.

         I. BACKGROUND

         Defendant Extreme Networks, Inc. (“Extreme” or “Company”) is a Delaware corporation that develops and sells network infrastructure equipment and related service contracts for warranty and maintenance of its equipment. Consolidated Compl. (“Compl.”) ¶¶ 2, 29, ECF 87. Defendant Charles W. Berger was the Company's President and Chief Executive Officer (“CEO”) and a member of Extreme's Board of Directors from April 2013 until April 19, 2015. Id. ¶ 31. Defendant John T. Kurtzweil was Extreme's Chief Financial Officer (“CFO”) and Senior Vice President from June 29, 2012 through June 1, 2014. Id. ¶ 32. From June 2, 2014 until September 30, 2014, Kurtzweil served as “Special Assistant to the CEO.” Id. Defendant Kenneth B. Arola was the Company's CFO and Senior Vice President from June 2, 2014 through May 2016. Id. ¶ 33.

         Lead Plaintiff Arkansas Teacher Retirement System (“Plaintiffs”) filed a class action complaint on behalf of all investors who purchased the publicly traded common stock of Extreme and/or exchange-traded options on such common stock between September 12, 2013, and April 9, 2015, (the “class period”). Id. ¶ 1. Plaintiffs allege that during the class period, Defendants falsely assured investors regarding the status of Extreme's acquisition of Enterasys Networks, Inc. (“Enterasys”), misrepresented the potential impact of the Company's partnership with Lenovo Group Ltd. (“Lenovo”), and falsely promised that the Company would achieve 10 percent revenue growth and 10 percent operating margin by the end of its fiscal year (“FY”) 2015.[1] Id. ¶¶ 12-14. Plaintiffs further allege that these misrepresentations and omissions led Extreme's stock to trade at artificially inflated prices during the class period. Id. ¶ 16. Plaintiffs offer statements by seven confidential witnesses (“CWs”) to suggest that the Individual Defendants knew of or deliberately disregarded the falsity of their statements at the time they were made.

         A. The Enterasys Integration

         i. Overview

         On September 12, 2013, Extreme issued a press release announcing an agreement to acquire Enterasys, a similarly-sized company based in New Hampshire, for $180 million in cash. Id. ¶ 4; Ex. 7 to Austin Decl., ECF 89-9 (Sept. 12, 2013 press release). The acquisition roughly doubled the size of the Company, and the Company described it as a “merger of equals.” Id. The market reacted favorably to statements regarding the immediate value that the acquisition would add to Enterasys. Id. ¶ 174. As a result, Extreme's stock price increased seven percent by $0.30 per share, from $4.03 per share at the close of trading on September 11, 2013, to $4.33 per share at the close of trading on September 12, 2013. The merger closed on October 31, 2013, during Extreme's Second Quarter (“Q2”) 2014. Id. ¶ 53.

         On November 4, 2013, Extreme issued a press release announcing its financial results for Extreme's First Quarter (“Q1”) 2014 and its Q2 2014 guidance. Id. ¶ 177. Among other things, the press release stated that Chris Crowell, the former CEO of Enterasys, had been retained as the Chief Operating Officer (“COO”) of Extreme, with direct responsibility for “sales and marketing.” Id. In the press release, Berger touted Extreme's “considerable progress” in the integration of Enterasys. Id. On a conference call that same day, Berger reiterated that the integration was progressing well. Id. ¶ 178. After this announcement, the Company's stock price increased from $5.38 per share to $6.30 per share. Id. ¶ 182.

         Before the market opened on February 5, 2014, Extreme issued a press release announcing its Q2 2014 financial results and its Q3 2014 guidance. Id. ¶ 188. Extreme reported revenues toward the low end of the guidance announced in its November 4, 2013, press release for Q2 2014, and expected reserves for Extreme's Third Quarter (“Q3”) 2014 below the consensus estimates of $154 million. Id. During a conference call with investors to discuss this announcement, Berger acknowledged that the Company had “not seen significant evidence of revenue [due] to synergies.”[2] Id. After this disclosure, the Company's stock declined from $7.04 per share to $5.92 per share. Id. ¶ 189.

         At the close of Q3 2014, Extreme released two press releases after trading hours. Id. ¶ 199. These announcements reported financial results for the first full quarter since the acquisition was complete. Id. The first announced Company revenues for Q3 2015 that were again on the low end of the guidance given at the end of the prior quarter. Id. The press release also announced the transition of Kurtzweil from CFO to “Special Assistant to the CEO” and the hiring of Arola as CFO. Id. ¶ 200. The second press release on May 6, 2014, announced the departure of Chris Crowell, COO of Extreme and former CEO of Enterasys. Id. On an earnings call that same day, Berger disclosed that Extreme “ha[d] experienced some integration issues, ” and announced that the field organizations and corporate marketing would report to him effective immediately. Id. ¶ 201. Following these announcements, the Company's stock declined $1.38 per share. Id. ¶ 202 (share price was $3.95 per share at the close of trading the next day).

         On June 21, 2014, two weeks before Extreme released its official Fourth Quarter (“Q4”) 2014 financial results, the Company issued a press release announcing higher guidance for Q4 2014. Id. ¶ 213. In the press release, Berger stated that “[o]ur integration remains ahead of plan as we continue to execute against key Company and operational and financial milestones, including successfully completing our ERP integration in early July[.]” Id. Berger and Arola continued to tout the successes of the integration through October 2014, when Extreme preannounced disappointing Q1 financial results. Id. ¶¶ 217-27.

         In October 2014, Extreme issued a press release announcing that Extreme's reported revenues were approximately $15 million below the Company's prior guidance and its Non-GAAP Net Income per Diluted Share would be break-even despite prior announcements that it would be between $0.06 and $0.08. Id. ¶ 227. Berger attributed the results to “significant delays in closing deals” in North America, but reassured investors that Extreme had “made dramatic progress” with the Enterasys integration, including hiring Jeff White as Chief Revenue Officer (“CRO”). Id. ¶¶ 227-28. The day after these disclosures, Extreme's stock fell by approximately 18 percent, declining from $3.76 per share to $3.06 per share. Id. ¶ 228.

         Later that same month, Extreme issued a press release announcing its financial results for Q1 2015 and its Q2 2015 guidance. Id. ¶ 223. Extreme's reported revenue for Q1 2015 was slightly above the Company's preannounced results. Id. In the press release, Berger reassured investors that Extreme was “on track to realize the full $30 to $40 million in cost synergies expected from the acquisition, ” and that the Company had “made significant progress towards finalizing the integration.” Id. Later that day, Berger and Arola hosted an earnings call with analysts to discuss the Q1 2015 financial results. Id. ¶ 234. During that call, Berger acknowledged that the low revenue and top-line growth were caused by “significant” “disruptions” resulting from the ongoing Enterasys integration efforts. Id. Berger, however, assured investors that “these disruptions are now fully behind us.” Id.

         In January 2015, while Arola touted the success of the integration, its customers, and quality of its products and services, he also suggested that Extreme would not be able to deliver on its commitment of 10 percent growth by the end of FY 2015. Id. ¶ 249. After making this disclosure, Extreme's stock declined from $3.36 per share to $3.20 per share, and continued to decline for two weeks. Id. ¶ 250. Later that month, Extreme announced its Q2 2015 financial results and its guidance for Q3 2015. Id. ¶ 254. Extreme's revenue was in line with the original guidance, and its expected revenue was slightly lower than analysts' expectations. Id. During a January 28, 2015, earnings call, Berger stated that the Company would not be able to deliver the 10 percent year-over-year growth that he and the other Defendants had projected from the beginning of the Enterasys acquisition. Id.

         ii. Alleged False Statements

         Plaintiffs allege that Defendants made a number of false and misleading statements related to the acquisition during the class period. Primarily, these statements fall into the following categories: (1) statements touting the success of the integration without disclosing the “failures”; (2) claims that the integration was “on track”; and (3) statements announcing the financial expectations of the acquisition despite having no reasonable basis for such statements.

         Plaintiffs identify numerous statements falling into each category. The Court offers the following as examples:

• The acquisition “is expected to be immediately accretive.” Id. ¶¶ 168 (Sept. 12, 2013), 170 (would produce “significant value” for shareholders) (same date).
• The revenue of the combined companies “will be approximately double that of either company alone.” Id. ¶¶ 169 (Sept. 12, 2013), 172 (same date).
• “[W]e plan to reduce product costs and operating expenses between $30 million to $40 million . . . over a 12 to 24-month period.” Id. ¶¶ 169 (Sept. 12, 2013), 180 (Nov. 4, 2013), 194 (Feb. 5, 2014), 220 (Aug. 14, 2014), 228 (Oct. 15, 2014).
• “There will be no disruption in customers' ability to grow and operate their networks.” Id. ¶¶ 170 (Sept. 12, 2013), 192 (Feb. 5, 2014).
• “We have already made considerable progress towards integrating the two companies including establishing the executive leadership team.” Id. ¶¶ 177-78 (Nov. 4, 2013).
• “[O]ur integration efforts are on track.” Id. ¶¶ 178 (Nov. 4, 2013), 190 (Feb. 5, 2014).
• “The senior management team for the combined Company has been established and we continue to make steady progress towards a complete integration.” Id. ¶ 190 (Feb. 5, 2014).
• “We see [the integration] getting dramatically better with a couple of things, the combination of sales forces under the leadership of our now head of North American sales John Fabiaschi, who came from Enterasys with strong performance there.” Id. (Feb. 5, 2014).
• “[W]e have started to make significant cuts, particularly in removing duplicative and very expensive senior management in the sales organization. We've got a similar move already in the marketing organization. I think you will see more of those synergies in this quarter and certainly next.” Id. ¶ 195 (Feb. 5, 2014).
• “We expect to have [the integration of the sales teams] complete late summer early fall [2014].” Id. ¶ 192 (Feb. 5, 2014), 220 (“[T]he two companies are now fully integrated . . . .”) (Aug. 14, 2014).
• “[O]ur sales force integration is complete.” Id. ¶ 217 (Aug. 14, 2014).
• “[T]he combined company is in a better position than ever to seamlessly deliver value to the customer.” Id. (Aug. 14, 2014).
• “On the whole, the integration has significantly exceeded my expectations.” Id. ¶ 218 (Aug. 14, 2014).
• “Overall, we are exactly where we planned to be in [the] integration process and the realization of the related financial synergies . . . . We completed major elements of the integration of Enterasys and are on track to realize the synergies we have committed to.” Id. (Aug. 14, 2014).
• “[W]e expect to achieve a 10% non-GAAP operating margin in Q4 and beyond.” Id. (Aug. 14, 2014)

         Plaintiffs claim that these statements were false because: (1) Extreme's acquisition of Enterasys “wasn't a very good deal”; (2) Extreme lacked an appropriate integration plan or product roadmap for the combined Company; (3) they incorrectly implied that the combined Company would achieve over $600 million in annual revenues due to its lack of overlap in revenue sources while failing to mention the substantial overlap between the two companies' salesforce, region, and products/services; (4) they incorrectly implied that the lack of customer overlap would help the joint Company achieve annual revenues in line with their separate trailing revenues; (5) Extreme's revenue and ability to create cost-saving synergies depended on successfully integrating Enterasys, but the Company was experiencing substantial integration problems that were not disclosed; (6) Defendants lacked a reasonable basis to expect to achieve $30 to $40 million in cost savings within the promised time frame; (7) Defendants touted positive aspects of the integration without disclosing the negative aspects, such as significant cuts of duplicative senior positions without disclosing the fact that numerous redundancies remained; and/or (8) gave the false impression that Extreme's cost cutting measures would materialize in increased profit margins in the near future, without disclosing that these cost cuts would not be sufficient to offset the loss of customers and business due to the integration problems. Id. ¶¶ 171, 173, 179, 181, 191, 193, 196, 214, 219, 221.

         Plaintiffs further allege that even after CEO Berger disclosed that Extreme had “experienced some integration issues, ” Defendants continued to mislead the market:

• Defendants represented that despite these issues, the integration was “ahead of plan, ” “ahead of schedule, ” “going very well, ” and would soon deliver the positive revenue impacts that had been predicted. Id. ¶¶ 203-05 (May 6, 2014), 223 (“I am confident . . . that virtually all of the[ integration challenges in the North American sales and partner organization] are behind us.”) (Aug. 14, 2014), 228 (Oct. 15, 2014), 233 (“During the quarter, we made significant progress towards finalizing the integration of the acquisition of Enterasys.”) (Oct. 28, 2014), 256 (Jan. 28, 2015).
• Defendants “reemphasize[d their] plan and [ ] commitment to attain double digit revenue growth by the second half of 2015” and a “10% operating margin on a non-GAAP basis.” Id. ¶¶ 204 (May 6, 2014), 223 (“[W]e expect to achieve a 10% non-GAAP operating margin in Q4 . . . .”) (Aug. 14, 2014), 235 (Oct. 28, 2014).
• “[T]he[ ] disruptions [to the integration efforts] are now fully behind us.” Id. ¶ 234 (Oct. 28, 2014).
• “We continue to [be on] track to realize the full $30 million to $40 million of synergies expected from the Enterasys acquisition.” Id. ¶ 235 (Oct. 28, 2014).
• “Although many deals were pushed out of the quarter, they remain in the pipeline, and we are confident in our ability to compete for these deals that were delayed from Q1.” Id. ¶¶ 238 (referring to “deal slippage”) (Oct. 28, 2014), 247 (Dec. 17, 2014). Additionally, in December 2014, Defendants first claimed that the integration was complete in some respects. Id. ¶ 245 (conversion to one ERP system and integration of sales team completed). Plaintiffs claim that these statements were false and misleading for many of the reasons stated above and because: (1) Defendants lacked any reasonable basis to expect to achieve double-digit revenue growth and 10 percent profit margin by June of 2015, and in fact failed to achieve such results; (2) the integration was a “failure”; (3) Extreme's revenue shortfalls could not be fully explained by “deal slippage” because numerous deals were lost due to undisclosed integration problems Id. ¶¶ 206, 219, 224, 236, 240.

         B. The Partnership with Lenovo

         i. Overview

         Plaintiffs allege that during the class period, Extreme's business model depended primarily on selling its products and services through other companies it called “channel partners.” Id. ¶ 6. One such partnership was with Lenovo, a global technology company. Id. Extreme first announced this partnership on July 17, 2013. Id. Throughout the class period, Defendants claimed that Lenovo was one of the Company's “key partnerships” as well as a key “growth driver” due to its expanding server business. Id. ¶¶ 7, 77. Defendants predicted that Extreme would begin to see “a lot of business” from Lenovo beginning in March 2014. Id. ¶ 75.

         On January 23, 2014, Lenovo announced that it would be expanding its server business by acquiring IBM's “x86” server business. Id. ¶ 76. After this announcement, Extreme adjusted its assessment of when it would begin to reap the benefits of the partnership. For example, on May 6, 2014, Berger stated that the Company expected the relationship “to have meaningful revenue impact in the second half of fiscal 2015.” Id. ¶ 81. Berger continued to tout the “key partnership” with Lenovo throughout 2014. In early Fall 2014, Berger announced that he had “met with the Lenovo executive team in China” and it was clear to him that “they are strongly committed to the alliance.” Id. ¶ 83. He also stated that Extreme expected “to attain year-over-year double-digit revenue growth in the fourth fiscal quarter, driven by our expected ramp of the Lenovo business.” Id. On October 28, 2014, Berger stated that the two companies “continue to make progress each day towards realizing the potential of this agreement, ” and anticipated “significant results by the fourth quarter.” Id. ¶ 89. He further stated that “there [was] no longer any doubt that this will happen, ” and that he expected to achieve double-digit revenue growth as a result of the partnership by the end of 2015. Id. After the October 28 announcements, Extreme's stock increased from $3.30 per share to $3.79 overnight. Id. ¶ 292.

         In mid-January 2015, CFO Arola touted the success of the Enterasys integration and Extreme's customers, products, and services during a public presentation at the Needham Growth Conference. Id. ¶ 294. After the presentation, however, Plaintiffs allege that Arola implied that Extreme would not be able to deliver on its commitment of 10 percent growth by the end of FY 2015. Id. Arola was also more ambiguous about the potential impact of the Lenovo partnership:

[We are] evaluating where we are with things like our Lenovo relationship, how much business we'll get in our quarter-four timeframe in relation to that business . . . . I don't want to make a comment about the 10% and the 10%, but our long-term view of the business if you ask me should be running this business at ¶ 10% operating margin pretty consistently over time.

Id. After this disclosure, Extreme's stock declined from $3.36 per share to $3.20 per share overnight. Id. ¶ 295. Two days after the disclosure, Extreme's stock declined further. Id.

         During the Company's January 28, 2015, earnings call to discuss financial results for its 2Q 2015, Berger revealed that the revenue impact the Company anticipated as a result of the partnership with Lenovo would not be achieved by June 2015, and perhaps not for another year. Id. ¶ 92. Nevertheless, he expressed confidence in the relationship between the two companies, claiming that the “partnership with Lenovo strengthened during the quarter on many fronts, ” with “continued productive discussions at all levels with Lenovo.” Id. ¶¶ 92, 298. After these disclosures, the Company's stock price increased from $2.78 per share to $3.04. Id. ¶ 301.

         ii. Alleged False Statements

         Plaintiffs allege that Defendants made a number of false or misleading statements in connection with Extreme's partnership with Lenovo. The Court offers the following as illustrative of the types of statements Plaintiffs claims were false or misleading:

• “[T]he Lenovo agreement, which we announced [in July 2013], will start to go into full swing this month.” Id. ¶ 265 (Nov. 4, 2013).
• Given Lenovo's business plans, Extreme “should see a pick up [in business] coming into the March quarter.” Id. (Nov. 4, 2013).
• “We continue to be [Lenovo's] only networking partner, and we will be now included in a price list shared by 1200 more sales people they are getting as part of the acquisition [of IBM's server business], assuming it stays on track and closes in 6 to 9 months and we just see this as tremendously positive.” Id. ¶ 272 (Feb. 5, 2014).
• “I want to again reemphasize our plan and commitment to attain double digit revenue growth by the second half of 2015 as we . . . realize the benefits of our key partnerships like Lenovo and Ericsson . . . .” Id. ΒΆΒΆ ...

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