Reprinted with permission from the June 8, 2011 issue of the Delaware Business Court Insider © 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
A classic race to the courthouse ended in March of this year without a winner. The starting gun was fired on Dec. 3, 2007, when VeriFone Holdings Inc. announced that its operating income for the preceding three quarters had been overstated by 129 percent.
The first plaintiffs reached the federal courthouse in northern California the next day, filing the first of nine class action complaints on behalf of the company’s shareholders, alleging securities fraud against VeriFone and its management. The first derivative plaintiff, Charles King, filed his complaint on Dec. 14, 2007, seeking to hold VeriFone’s officers and directors liable to the company for any damages that might be assessed against VeriFone in the class actions. The early filers had a head start, but the race was long, and, of course, the race is not always to the swift.
On March 8, 2011, the U.S. District Court for the Northern District of California in In re VeriFone Holdings Inc. Securities Litigation dismissed the remaining VeriFone securities-fraud suits with prejudice, finding that the plaintiffs had failed to adequately allege that the company’s management acted with scienter, that is, that they made false or misleading statements either intentionally or with “deliberate recklessness” in order to “deceive, manipulate or defraud” buyers or sellers of the company’s stock. Hoping for a second wind, the plaintiffs filed a notice of appeal with the 9th U.S. Circuit Court of Appeals on April 5.
The district court’s decision marks the finish line for the first leg of what has become an ultra-marathon of litigation, involving VeriFone, its officers, directors, and stockholders, the Securities Exchange Commission, the federal court in California, the Delaware Court of Chancery and the Delaware Supreme Court in more than a dozen legal actions.
Race Goes to the Fleetest
The “race to the courthouse” has been the target of criticism and reform efforts in recent years, attacked as an evil in a system that relies in part on watchful stockholders to police corporate misconduct and impose liability on disloyal corporate fiduciaries. Plaintiffs’ lawyers may file hastily drafted complaints, sometimes within hours of the breaking of corporate bad news, or the announcement of a transaction, sometimes based on no more than a press release or a newspaper report.
The only reason for their urgency is to gain advantage in the competition for lead-counsel status, and to take the winner’s share of attorney fees in any settlement or fee award. Their many critics say that such haste makes waste for corporations forced to address multiple, virtually automatic complaints and litigate serial amended pleadings, and for the broader constituency of stockholders who bear the cost.
In federal court, the Private Securities Litigation Reform Act of 1995 (PSLRA) established a procedure for choosing lead plaintiffs and their counsel, with the intention of removing at least some of the incentives for racers. However, the PSLRA procedure does not apply to derivative actions, the first-to-file presumption remains strong, and the race may still go to the swiftest. Among the VeriFone derivative plaintiffs, King took the lead from the start, and held it until August 2010, when his California action was dismissed for the second and final time. (See the 2010 Northern District of California opinion in In re VeriFone Holdings Inc. Shareholder Derivative Litigation.)
Earlier this year, however, King achieved a pyrrhic victory in Delaware, where criticism of the race to the courthouse has been harsh. Since 2006, the Delaware Court of Chancery has been especially wary of firms it views as “early filers,” “frequent filers” or “pilgrims” (early settlers). On Jan. 28, 2011, in King v. VeriFone Holdings Inc., the Delaware Supreme Court ruled in King’s favor, reversing a May 2010 decision in which the Chancery Court rebuffed an attempt by King to resuscitate his California Derivative Action after it was dismissed the first time. Unfortunately for King, the reversal came too late.
Court: Command to 'Fix It' Not Code for 'Falsify It'
“Figure it out” and “fix the problem.” As reported by the court in the securities class action, those were the instructions VeriFone’s CEO, Douglas Bergeron, and its CFO, Barry Zwarenstein, gave to their finance managers in February 2007. The court’s March 8 opinion explains that, because preliminary first-quarter results showed margins 4 percent below their previous guidance to analysts, VeriFone’s CEO and CFO allegedly began to express “increasing frustration” in their e-mails to management and even went so far as to characterize the shortfall as an “unmitigated disaster.”
According to the court, Paul Periolat, VeriFone’s supply chain controller, allegedly determined that the discrepancy was caused by incorrect accounting for inventory by a foreign subsidiary. To address the error, Periolat allegedly made $7 million in manual inventory adjustments, but did not confirm his adjustments with the foreign subsidiary’s controller. As the court also explained, at the end of the second and third quarters, VeriFone’s preliminary results again showed lower gross margins than the company’s forecasts, and, again, Periolat allegedly determined that errors in inventory accounting caused the discrepancies and, to correct such errors, authorized approximately $20 million in manually adjusted increases to inventory for the second and third quarters combined.
The court further reported that, on Dec. 3, 2007, VeriFone announced that the company’s operating income had been overstated by 129 percent, and that, by the end of the day, the company’s price fell by over 45 percent, from $48.03 to $26.03 per share. The first class action lawsuit was filed the next day, with more to follow in rapid succession.
As explained in its March 8 opinion, the court found that the most plausible inferences were that Periolat believed that his adjustments were correct, that Zwarenstein’s directions to management to “fix it” were not understood as “coded instructions” to falsify the books, that Periolat’s previously reliable record allowed Bergeron and Zwarenstein to rely on his expertise, and that the two officers had no basis to assess whether Periolat’s changes were unreasonable.
No Time for PreSuit Demands
Unless reversed on appeal, the March 8 opinion in the securities class action ended the race for the last of the VeriFone plaintiffs. For the derivative plaintiffs, the race ended sooner, but was more arduous. In a derivative action, a stockholder seeks relief on behalf of the corporation. Damages, if any, are paid to the corporation by the officers and directors who allegedly breached their fiduciary duties to the corporation and its stockholders. The claims belong to the corporation, and the right to bring the action belongs in the first instance to the corporation, through its board of directors. A stockholder who would bring an action derivatively is therefore required to plead in his complaint that he either made a demand on the corporation’s board of directors to bring the action, or that he did not make the effort because such a demand would have been futile.
The presuit demand requirement is based on the principle that a corporation’s business and affairs are managed by its board of directors, and the presumption that directors will act in good faith and in the best interests of the corporation. A plaintiff may plead demand futility by alleging facts sufficient to show that a majority of the directors either had, or were controlled by someone who had, a personal interest in the challenged transaction. Demand is not excused merely because the directors would have to “sue themselves.” Derivative plaintiffs, in their haste to get to the courthouse, may fail to give appropriate deference to the board by taking the time to determine whether the directors are capable of considering a demand, or are rendered incapable by their personal interests.
In a class action in federal court, the Private Securities Litigation Reform Act automatically stays discovery upon the filing of a motion to dismiss. Where derivative complaints are filed in conjunction with class actions, as in VeriFone, federal courts consistently hold that the stay bars the derivative plaintiffs from taking discovery to show that demand would have been futile. Thus, early-filed derivative complaints that fail to meet their pleading requirements may be dismissed without an opportunity for discovery. Such a dismissal, however, need not be fatal. Courts may dismiss a derivative action without prejudice, allowing the plaintiff to re-plead or amend the complaint after gathering the necessary facts.