Police and Fire Retirement System of the City of Detroit v. Crane et al
Filing
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Order by Hon. Vince Chhabria granting 39 Motion to Dismiss with Leave to Amend.(vclc2S, COURT STAFF) (Filed on 6/4/2014)
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UNITED STATES DISTRICT COURT
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NORTHERN DISTRICT OF CALIFORNIA
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POLICE AND FIRE RETIREMENT
SYSTEM OF THE CITY OF DETROIT,
Plaintiff,
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v.
ROSEMARY A. CRANE, et al.,
Case No. 13-cv-00945-VC
ORDER GRANTING MOTION TO
DISMISS WITH LEAVE TO AMEND
Re: Docket No. 39
Defendants.
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United States District Court
Northern District of California
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In this putative class action, the Police and Fire Retirement System of the City of Detroit
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("Retirement System") alleges that Epocrates and two of its executives, Rosemary Crane and
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Patrick Spangler, defrauded investors by: (i) failing to disclose serious delays in the company's
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ability to recognize deferred revenue from DocAlerts; and (ii) making materially misleading
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statements about the company's ability to recognize, and predict the timing of, revenue from
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DocAlerts. The defendants have filed a motion to dismiss, which is granted with leave to amend.
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The complaint pleads facts that raise a very strong inference that, in early 2011, the
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company was experiencing a very serious problem with revenue recognition for DocAlerts – a
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problem that was likely to materially affect the company's financial results in future quarters. If
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Crane and Spangler were aware of the seriousness of this problem, their failure to disclose it to the
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investing public would constitute securities fraud – particularly their failure to disclose it in
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connection with the statements they made in March and May (when they announced their
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quarterly results for the fourth quarter of 2010 and the first quarter of 2011, respectively).
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However, the complaint falls slightly short of alleging facts sufficient to create a strong
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inference that the defendants acted with the required state of mind when they failed to disclose the
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problem. Although the complaint adequately alleges Crane and Spangler were aware by at least
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February that the company's problem with DocAlerts could have a significant impact on first
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quarter financial results (indeed, they began having daily meetings about it with the finance team,
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including CW1), it falls short of alleging facts that would show they knew or suspected the
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problem would likely have a significant effect on results in future quarters. After all, as the
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complaint itself acknowledges, the company's contract-restructuring efforts succeeded in closing
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the gap between the company's original performance projections for the first quarter of 2011 and
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CW1's updated projections based on his discovery of the problem with the DocAlerts. Compl. at
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¶¶ 57-58. To successfully allege that the defendants intended to deceive the investing public, the
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complaint would need to raise a strong inference that Crane and Spangler knew (or suspected) that
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the first-quarter contract restructuring process was but a temporary band-aid that would not help
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the company avoid performance shortfalls (or that would exacerbate shortfalls) in future quarters.
Although the complaint alleges this, it does not do so with sufficient detail or specificity.
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United States District Court
Northern District of California
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For example, the complaint repeatedly asserts that the contract renegotiation process "artificially
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inflated the Company's reported revenue in 1Q 2011 at the expense of revenue in subsequent
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quarters," Compl. at ¶ 6, but it does not specifically indicate that Crane and Spangler were aware
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or suspected that the renegotiation process was merely a band-aid that masked (or exacerbated)
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deficiencies in future quarters. Similarly, paragraph 58 alleges: "CW2 and the rest of the revenue
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accounting team wondered how the Company could possibly meet its 2Q 2011 revenue
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expectations, because there were not enough customer contracts that could be repapered." But this
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allegation does not lay knowledge at the feet of Crane and Spangler. And paragraph 57 alleges:
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"CW1 stated that the Company had already accelerated DocAlert revenue from the second quarter
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to the first quarter, and had tried to accelerate DocAlert revenue from the third quarter to the
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second quarter, but that proved not to be feasible." This also does not create a strong inference
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that Crane and Spangler knew or suspected all along that the restructuring efforts were a mere
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first-quarter band-aid.
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As discussed above, the question whether the complaint raises a strong inference of
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scienter beginning in February 2011 is a close one. Less close is the question whether the
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complaint successfully alleges that Crane and Spangler, with the required state of mind, made
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material omissions or false statements in connection with the company's February 1, 2011 IPO.
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The complaint very generally describes one January meeting involving CW1, Crane and Spangler
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in which they discussed the problem and agreed the company needed to address it. Compl. at ¶
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40. But the daily meetings to address the revenue shortfall did not begin until February, and the
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general allegation about the January meeting, on its own, does not raise a strong inference that
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Crane and Spangler intended to deceive the investing public by not disclosing the problem during
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the IPO.
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Finally, the complaint alleges the company violated Generally Accepted Accounting
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Principles ("GAAP") in several respects. The complaint does not make clear how important these
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allegations are to the Retirement System's fundamental contention that the defendants acted with
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scienter by failing to disclose the revenue-recognition problems with DocAlerts.
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argument, counsel for the Retirement System asserted that the GAAP violations would have
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United States District Court
Northern District of California
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rendered the company's quarterly financial statements fraudulent, but that the GAAP violations
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were not necessary to support the more fundamental allegation that the defendants intended to
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defraud the investing public by failing to disclose the DocAlert problems. In any event, the
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complaint fails to plead a GAAP violation with sufficient specificity. For example, the complaint
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alleges that under FASB Accounting Standards Codification 605-25-25-5, Epocrates was
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precluded from recognizing any DocAlert revenue until all DocAlerts called for by a contract with
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a pharmaceutical company were disseminated to subscribers. Compl. at ¶¶ 104-131. But as
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counsel for the Retirement System acknowledged at argument, this would only be true if
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pharmaceutical companies had the right to "return" individual DocAlerts once they were
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disseminated to subscribers. The complaint does not coherently allege that such a right existed,
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and it is difficult to imagine that it could do so. The complaint also alleges Epocrates engaged in
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illegal revenue and earnings management in violation of SEC Staff Accounting Bulletin 99,
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Compl. at ¶¶ 132-35, but that Bulletin speaks to a much narrower and more specific question
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whether a company must correct its financials if it discovers an error that is presumptively
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immaterial. The complaint further alleges that the company violated ASC 605-25-50-2 by failing
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"to disclose the Company's practice of canceling and renegotiating the terms of the DocAlert
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contracts," Compl. at ¶ 136, but this allegation is made in passing and without any explanation.
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For these reasons, the complaint is dismissed, with leave to amend. The Retirement
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System shall have 21 days from the date of this order to file an amended complaint.
IT IS SO ORDERED.
Dated: June 4, 2014
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VINCE CHHABRIA
United States District Judge
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United States District Court
Northern District of California
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