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DANIS v. USN COMMUNICATIONS

October 8, 1999

DAVID DANIS, ON BEHALF OF HIMSELF AND ALL OTHERS SIMILARLY SITUATED, PLAINTIFF,
v.
USN COMMUNICATIONS, INC., J. THOMAS ELLIOTT, GERALD J. SWEAS, MERRILL LYNCH & CO., COWEN & COMPANY AND DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION, DEFENDANTS.



The opinion of the court was delivered by: Conlon, District Judge.

    MEMORANDUM OPINION AND ORDER

Plaintiffs in this putative class action sue various defendants for violation of the securities laws in connection with the purchase of stock of USN Communications, Inc. ("USN") in 1998. Defendants seek to dismiss the consolidated class action complaint ("complaint") pursuant to Fed. R.Civ.P. 9(b) and 12(b)(6), and § 21D(b) of the Private Securities Litigation Reform Act ("PSLRA"), 15 U.S.C. § 78u-4(b).

BACKGROUND

For purposes of a motion to dismiss, this court accepts all well-pleaded allegations in the complaint as true and drawn all reasonable inferences in favor of the plaintiff. See Travel All Over the World Inc. v. Kingdom of Saudi Arabia, 73 F.3d 1423, 1429 (7th Cir. 1996). Before treating the substance of the allegations, it is necessary to describe the parties and claims.

I. PARTIES AND CLAIMS

A. Putative Plaintiff Class

The putative plaintiff class consists of two groups of purchasers of USN common stock: those who purchased stock pursuant to USN's registration statement/prospectus of February 2, 1998 and the final prospectus of February 4, 1998 (collectively, "registration statement/prospectus"), and those who purchased USN stock during the "class period" between February 4, 1998 (the date of USN's initial public offering) and November 20, 1998. Compl. ¶ 1.

B. Individual Defendants

The individual defendants are: Thomas Elliot, USN's President and CEO since April 1996, Gerald Sweas, USN's Executive Vice President and Chief Financial Officer, and nine USN "directors most of whom either owned USN stock or represented entities owning USN stock at the time of the initial public offering Richard Brekka, Dean Greenwood, Donald Hofmann, James Hynes, William Johnston, Ian Kidson, Paul Lattanzio, David Mitchell, Eugene Sekulow. Id.¶¶ 16-26.

Plaintiffs contend these individual defendants, due to their stock ownership, status as high-level managers or directors, and/or representation of entities owning 84% of USN's common stock prior to the initial public offering, and 64% thereafter, had knowledge of and control over USN's operations and practices. Id. ¶¶ 27, 189.

C. Underwriter Defendants

Plaintiffs sue three underwriter defendants who managed the underwriting of USN's initial public offering: Merrill Lynch ("Merrill"), Cowen & Company, ("Cowen"), and Donaldson, Lufkin & Jenrette ("DLJ"). Merrill served as the lead manager of the initial public offering, after investing more than $135 million in USN in the form of stock, warrants exercisable for stock, and notes convertible to stock. Id. ¶¶ 32,188. Merrill also brought in a number of venture capital firms to invest in USN prior to the initial public offering, the same firms represented by many of the individual defendants serving as USN directors. Id. ¶¶ 33,189. Plaintiffs sue the three underwriter defendants individually and as representatives of the class of all underwriters who participated in the initial public offering.

D. Deloitte & Touche

Defendant Deloitte & Touche ("Deloitte") audited USN's financial statements for the 1996 and 1997 fiscal years. Id. ¶ 41. Deloitte provided consulting services regarding USN's technical infrastructure prior to and during the class period. Id.

E. The Claims

In Count I, plaintiffs sue all defendants under § 11 of the Securities Act of 1933, ("Securities Act") and the individual defendants under § 15 of that Act. In Count II, plaintiffs sue the individual and underwriter defendants under § 12 of the Securities Act. In Count III, plaintiffs sue all defendants under § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), and Rule 10b-5 promulgated thereunder. In Count IV, plaintiffs sue the individual defendants under § 20(a) of the Exchange Act.

II. THE PURPORTED SCHEME TO "FLIP" USN

USN is a company spawned by the Telecommunications Act of 1996.*fn1 A primary goal of the act is to promote competition in local and long distance telecommunications markets. Among other things, the Act obligates Regional Bell Operating Companies ("RBOCs"), such as Ameritech, to open their local network monopolies to competition. This has resulted in the birth of companies known as "local telecommunications resellers," such as USN. These resellers purchase various local and long distance telecommunications services (such as local and long-distance telephone, voicemail, and paging services) from the RBOCs, "bundle" them into a single package of services, and then sell that package to the public. Id. ¶¶ 2, 15. As a reseller, USN sought to persuade the RBOCs' existing customers to switch to USN by offering them packaged services for lower rates. Id. After gaining a new customer, USN would then have to "provision," or switch, the new customer from their existing telephone company over to USN. Id.

But according to plaintiffs, the individual and underwriter defendants never intended to develop USN as a going concern. Id. ¶ 52. They had no intention of designing, developing, or implementing the technical infrastructure and controls necessary to provide telecommunications services and operate as a viable company. Id. Instead, those — defendants intended to "flip" USN — to take USN public, utilize the proceeds from the public offering to hire a sales force in order to quickly build the largest "book of business" of any reseller in the country, and to then sell USN and its account base to a larger, established telecommunications company that already had infrastructure and control systems in place. Id.

In order to accomplish this "flip" scheme, the individual defendants and Merrill issued numerous false statements prior to the initial public offering that conditioned the financial markets to believe that USN was experiencing impressive sales and revenue growth. Id. ¶ 50. Many of these statements touted USN's growth in relation to its competitors, stating the number of lines sold during various time periods, the productivity of its sales force, and its "state of the art" internal and provisioning systems. Id. ¶ 50. These defendants continued to issue similar false and misleading statements after the public offering, in the form of public press releases and annual and quarterly financial reports filed with the Securities Exchange Commission.

According to plaintiffs, the scheme almost worked. Less than one month after going public, GTE and AT & T contemplated purchasing USN and began performing due diligence. Id. ¶ 53. However, GTE and AT & T soon informed the individual defendants and Merrill that they would not purchase USN after discovering that USN lacked the technological infrastructure and customer account base that USN claimed it possessed. Id. ¶ 55. GTE and AT & T also revealed that because USN lacked the necessary systems, they had been unable to determine or confirm the number of lines purportedly sold and provisioned, the size of USN's customer base, and USN's reported revenue, accounts receivable, and assets. Id. ¶ 55.

Despite this knowledge that the "flip" strategy had failed, that USN lacked the provisioning and billing systems long touted by the individual defendants and Merrill, and that USN's reported revenue, accounts receivable, and operating results were inaccurate due to USN's lack of infrastructure and internal controls, plaintiffs claim that the individual defendants continued to issue numerous false and misleading statements throughout the class period. Id. ¶ 57.

Plaintiffs assert that on November 3, 1998, "the truth concerning USN's dire financial condition slowly began to emerge" and that on November 20, 1998, they learned more about "the true state of financial affairs at USN." Id. ¶¶ 179, 180. On November 3, USN issued a press release announcing its restructuring in order to drastically reduce its spending. Id. ¶ 179. The release explained that USN planned to eliminate 650 positions (approximately 46% of its workforce), primarily in its direct sales department. Id. According to the release, the restructuring was necessitated by USN's inability to secure additional capital for expansion and its resulting wish to focus on serving its existing customer base. Id. USN echoed these points in another release issued on November 20. Id. ¶ 180. As of November 20, USN's stock closed at $.50 per common share; at the time of the initial public offering, the stock was worth $16.00 per share, and at its high point during the class period, $23.00 per share. Id. ¶ 181.

III. USN'S INTERNAL PROBLEMS AND SUBSEQUENT MISREPRESENTATIONS

Plaintiffs claim that prior to and during the class period, defendants made numerous materially false and misleading statements that (1) misrepresented USN's provisioning capabilities, billing capabilities, and technological infrastructure, (2) overstated USN's revenues, accounts receivable, assets, and number of access lines purportedly sold and provisioned, and (3) understated USN's allowance for doubtful accounts, expenses, and net loss. Id. ¶¶ 3, 51.

First, USN reported fictitious revenue in a manner contrary to its stated revenue recognition policy and generally accepted accounting principles. This occurred because USN reported as "earned" that amount of revenue it believed it would receive from a new customer, even though it had not yet "provisioned" the customer over to USN or provided any services to the customer. Id. ¶¶ 65, 66, 67.

Second, USN reported fictitious sales. USN's salespeople were paid on a commission basis and would not receive any commission if they did not reach 50% of their monthly quota. As such, plaintiffs allege these salespeople routinely reported sales that did not actually occur — anywhere from 30-40% of all reported new sales — in order to meet their quota. Id. ¶¶ 71, 73. According to plaintiffs, defendants Elliot and Sweas often instructed the sales force to add a week or two to the quarter in order to "get the numbers up." Id. The sales managers who oversaw the sales department received a partial payment for every dollar earned by the sales department. Id. ¶ 75. Plaintiffs assert that this led managers to approve new sales they knew to be fictitious to collect their extra payment. Id. ¶¶ 76, 77.

Third, USN misrepresented its electronic provisioning capabilities. USN repeatedly boasted of its industry-leading electronic proprietary and provisioning interface systems and that these systems enabled it to provision more lines than would be possible if it had to provision orders by mail or facsimile. Id. ¶ 78. However, USN did not actually possess the capacity to provision new orders electronically because it tried, unsuccessfully, to combine a number of antiquated computer programs incapable of interfacing with each other. Id. ¶ 79. Because USN lacked the infrastructure to provision the orders electronically, the orders had to be provisioned — manually. Id. But manual processing took much longer; a two to three month lag often occurred between the time of a new sale and the time that new customer was actually provisioned over to USN. Id. ¶ 83. As a result of the delay, many customers who initially agreed to become USN customers later refused to be provisioned when actually contacted by USN. However, USN continued to report revenue earned from these customers even though they had never been provisioned or provided services by USN. Id. ¶ 89.

Fourth, at the time of the initial public offering and for most of the class period, USN failed to disclose its inability to bill its customers. Id. ¶¶ 94-95. USN advertised its ability to provide an integrated bill containing all of a customer's telecommunications service charges — local, long distance, paging, Internet, and cellular services — on a single statement. Id. ¶¶ 94, 97. However, USN did not have any automated billing system and could not generate these bills. Id. ¶¶ 95, 98. In fact, beginning in July 1997 and lasting through July 1998, USN retained a team of Deloitte information technology consultants to design a functioning billing system. Id. ¶ 95. The inability to bill customers severely compromised USN's cash flow and resulted at one point in 71% of USN's accounts receivable going unbilled. Id. ¶¶ 95, 96, 100. When USN's billing system was finally completed in July 1998, it still lacked the ability to properly process many of the charges imposed by the RBOCs. This resulted in ...


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