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DANIS v. USN COMMUNICATIONS
October 8, 1999
DAVID DANIS, ON BEHALF OF HIMSELF AND ALL OTHERS SIMILARLY SITUATED, PLAINTIFF,
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).
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.
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.
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.
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.
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
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.
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 ...