By order dated October 22, 2007, Judge David O. Carter of the U.S. District Court for the Central District of California substantially denied defendants’ motion to dismiss plaintiff’s class action complaint, finding that plaintiff adequately stated claims for violations of the Securities and Exchange Act (“Exchange Act”) under the pleading standards of the Private Securities Litigation Reform Act of 1995 (“PSLRA”).
Plaintiff Middlesex Retirement System, in its class action complaint, sued Quest Software, Inc., and certain of its senior officers and directors, alleging improper options backdating. The complaint alleged that every date on which Quest executives and/or directors were granted stock options from 2000 - August 2002 was the most or second most favorable date (i.e., the lowest stock price) in the month and, in most cases, one of the most favorable of the entire year. Plaintiff alleged that Quest admitted in a January 15, 2007 press release, that "accounting measurement dates for most of the stock option grants to employees from July 1998 to May 2002 differed from the recorded grant dates." As a result of its improper accounting for stock options, Quest announced it would restate its financial statements for a 5-year period because its aggregate pre-tax, non-cash stock-based compensation expense between July 1998 to May 2002 was understated by approximately $150 million. Plaintiff further alleged that defendants concealed their improper accounting for backdated stock options, and materially misrepresented the true amount of compensation Quest’s executives and directors were receiving, and that they were issuing stock options in accordance with a shareholder-approved 1999 Stock Option Plan, when they were not.
In one of the first decisions within the Ninth Circuit interpreting the recent Supreme Court decisions addressing pleading standards as set forth in Bell Atlantic Corp. v. Twombly, 127 S. Ct. 1955 (2007), and Tellabs v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), the District Court rejected defendants’ argument that the Tellabs decision in particular raised the standards for pleading a securities fraud claim under Section 10(b) of the Exchange Act in the Ninth Circuit, finding rather that the Supreme Court explicitly approved the prevailing Ninth Circuit standard.
The Court observed that the Complaint “has provided a highly detailed time line documenting the alleged backdating that occurred at Quest.” Rejecting defendants’ challenges to Plaintiff’s scienter allegations, the Court stated that it “finds the backdated stock options and the concurrent practices of the option-granting employees are highly suspicious and concludes that both lean heavily toward a finding of scienter,” thus satisfying the PSLRA’s requirement of pleading a strong inference of fraud.
The Court also rejected defendants’ argument that there was no strong inference of scienter because the granting procedures were “highly technical” and the backdating was the result of “the complexity of accounting for equity-based compensation.” The Court noted the “extremely fortunate dates” chosen as option grant dates and that “none of the option grant dates resulted in less-than-favorable results for Defendants” which “also gives rise to a strong suggestion that the improper dating of options was intentional.”
The Court found that “Defendants either knew or were deliberately reckless in not knowing that the purported option dates were improper.” The Court considered contrary inferences urged by defendants, but, concluded that, “[i]n the parlance of the Tellabs holding, the Court can definitively state that the inference that intentional backdating occurred at Quest is more ‘cogent and compelling’ than any opposing inference offered by Defendant.” For instance, the Court stated that it “finds it highly improbable that a failure to comprehend the proper accounting treatment of stock options would so consistently benefit Defendants. Regardless of whether the accounting is ‘highly technical,’ it can not cause option grant dates to mysteriously fall on some of the lowest priced dates of 2000, 2001, and 2002 without someone’s influence. Indeed, were such determinations as complex as Defendants argue, it would be expected that the option measurement dates would occasionally be detrimental to Defendants.”
The Court noted that Defendants were some of the primary beneficiaries of the backdated options, and also held key positions to control the measurement dates, strengthening the inference of their actual knowledge or deliberate recklessness. The Court found that “the measurement dates for determining when an option was effectively granted are not so complex as to cause confusion on the part of sophisticated public company executives.” The Court concluded: “Indeed, it is simply incomprehensible that for such large option grants Defendants would not have been keenly aware of the option measurement date and the resulting value of the option grants. Given that Defendants’ respective positions on the Compensation Committee, Audit Committee, as CFOs, etc., would have given Defendants detailed knowledge of when the options were actually granted, and given that the Court has already found (in no small part because of the press release issued by Quest itself) that extensive backdating occurred, Plaintiff’s [Complaint] has adequately pled that Defendants would have known or were deliberately reckless in not knowing about the backdated options. Thus, Plaintiff has pled a strong inference of scienter.” The Court also noted that defendants’ backdating abruptly stopped after August 30, 2002, the effective date of Sarbanes-Oxley §403, requiring option grants to be reported within two business days, and rejected defendants’ explanation that this cessation was wholly innocent as “highly implausible.”
The Court also found that plaintiff adequately pled the falsity of Quest’s financial statements due to the understatement of expenses associated with the backdated stock options, as well as defendants’ scheme liability, that plaintiff adequately stated “control person” allegations under Section 20(a) of the Exchange Act as to all but two defendants, and held in abeyance plaintiff’s insider trading claims under Section 20A of the Exchange Act, finding that materials attached to plaintiff’s brief adequately established contemporaneous trading, and noting that once such material is added to an amended complaint, defendants’ motion to dismiss this claim will be deemed denied.
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