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CHU v. SABRATEK CORP.

June 13, 2000

DENNIS CHU, AMBASSADOR WINDOW AND DOOR CO. PENSION PLAN AND TRUST, BRUCE BRAVERMAN, ET AL., INDIVIDUALLY AND ON BEHALF OF ALL OTHERS SIMILARLY SITUATED, PLAINTIFFS,
V.
SABRATEK CORPORATION, K. SHAN PADDA, ANIL K. RASTOGI, STEVEN L. HOLDEN, DORON C. LEVITAS, VINCENT J. CAPPONI, ALAN E. JORDAN, STEPHAN C. BEAL, ELLIOT R. MANDELL, SCOTT P. SKOOGLUND, WILLIAM D. LAUTMAN, WILLIAM H. LOMICKA AND KPMG LLP, DEFENDANTS.



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

  MEMORANDUM OPINION AND ORDER

Plaintiff Dennis Chu, on behalf of himself and all purchasers of the publicly traded securities of Sabratek Corporation ("Sabratek") between the period of February 25, 1997 and October 6, 1999, seeks remedies under § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5.*fn1 The plaintiffs contend that Defendant KPMG, LLP ("KPMG") knowingly or recklessly misrepresented material facts in connection with the purchase of Sabratek securities by certifying that Sabratek's 1997 and 1998 financial reports had been prepared in conformity with Generally Accepted Accounting Principles ("GAAP") and that it had audited Sabratek's financial statements in accordance with Generally Accepted Accounting Standards ("GAAS"). KPMG filed a motion to dismiss the plaintiffs' Third Amended Complaint ("complaint"), (R. 42-1), arguing that the plaintiffs have failed to comply with the heightened pleading requirements of Rule 9(b) of the Federal Rules of Civil Procedures and the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. § 78u-4(b). We agree with KPMG that the plaintiffs have failed to allege facts which give rise to a strong inference that KPMG either knew or recklessly disregarded Sabratek's improper revenue recognition practices. The plaintiffs have, however, alleged sufficient facts to show that KPMG either knowingly or recklessly made a material misstatement when it certified approximately $39 million of Sabratek's expenses as intangible assets in violation of GAAP and GAAS. Therefore, we grant in part and deny in part KPMG's motion to dismiss.

FACTS

For purposes of a motion to dismiss, this Court accepts as true all well-pleaded allegations in the complaint and draws all reasonable inferences in favor of the plaintiffs. See Travel All Over the World, Inc. v. Kingdom of Saudi Arabia, 73 F.3d 1423, 1429 (7th Cir. 1996). In accordance with this standard, we recite the facts relevant to KPMG's motion.

Sabratek Corporation ("Sabratek") incorporated in 1990 with the strategic goal of becoming a comprehensive solution provider to the alternative healthcare market. In particular, Sabratek sought to create a so-called "virtual hospital room" that would enable healthcare providers to treat and monitor patients in alternate care facilities. Sabratek's products, which include infusion pumps for the delivery of therapeutic agents and diagnostic and information systems for patient monitoring, allow healthcare providers to treat high-acuity patients in such places as long-term care facilities, outpatient centers, and patients' homes. With Sabratek's products, healthcare providers can reduce operating costs while improving the delivery and quality of care. (Compl. at ¶¶ 1, 24, 43.) Since going public in June 1996, Sabratek common stock experienced dramatic increases in price. At its highest point during the putative class period, Sabratek common stock reached the price of $38.75 per share. (Compl. at ¶¶ 2, 45.)

In the meantime, the plaintiffs contend that Sabratek's business was experiencing a number of material adverse problems. Although Sabratek repeatedly touted the benefits of its product line, Sabratek experienced significant safety and compliance problems. At all material times prior to and during the putative class period, Sabratek manufactured its line of Rocap flush syringes without Food and Drug Administration ("FDA") approvals. (Compl. at ¶ 46.) Sabratek also began to lose its customer base and experienced a growing level of customer complaints about the quality of its products. (Id.) The net effect of these problems was that Sabratek's supply of unsold products, specifically its infusion pumps, increased to "damagingly high levels." (Compl. at ¶ 5.) In light of these and other problems, Sabratek began to lose market share to its competitors.

The plaintiffs allege that starting no later than February 25, 1997, the defendants, including KPMG, engaged in an elaborate accounting scheme to conceal Sabratek's declining sales and other profit-related problems. KPMG was the consultant and auditor who certified Sabratek's 1997 and 1998 annual financial statements, which were filed with the SEC and disseminated to the public. The plaintiffs allege, inter alia, that Sabratek engaged (and KPMG acquiesced) in numerous improper revenue-inflating and expense-deflating practices in violation of GAAP. Sabratek's improper practices included: (1) recognizing revenue on "phony sales" of products to entities that had not ordered Sabratek products; (2) recognizing revenue on "inventory parking arrangements"; (3) booking revenue on "consignment sales" where no bona fide purchase had been made; (4) backdating invoices for premature revenue recognition; (5) concealing substantial credits, discounts, and/or rebates offered to distributors; and (6) paying itself "consulting fees" for fictitious consulting services where no money ever exchanged hands and no invoices were ever generated. (Compl. at ¶¶ 6, 48-51.)

In addition, the plaintiffs allege that Sabratek, with the approval of KPMG, structured various fraudulent transactions with four entities: Unitron Medical Communications, Inc. ("Unitron"), GDS Technology, Inc. ("GDS"), Healthmagic, Inc. ("Magic"), and Collaborations in Healthcare, LLC ("Healthcare"). Through their transactions with Unitron, GDS, Magic, and Healthcare (collectively "R & D Satellite Entities"), Sabratek reported approximately $39 million of cash disbursements and research expenses as licensing deals, loans, and other "intangible assets."*fn2 (Compl. at ¶ 53.)

Sabratek's improper accounting practices artificially depressed Sabratek's expenses and inflated its reported revenues, income, and earnings per share. Sabratek reported its inflated figures on its quarterly and annual financial forms, which received positive market feedback. But on October 7, 1999, after delaying its second quarter financial statements by two months, Sabratek announced that its previously reported earnings, as reflected in its 1997 and 1998 financial statements, had been overstated by approximately $39 million. Sabratek also announced that its board was considering certain unspecified "other accounting issues" that had been raised by Sabratek's CFO. Sabratek's closing stock price of $1.03 per share on October 7, 1999 represented a dramatic decline of more than 97% from its class period high of $38.75 per share in September 1997. (Compl. at ¶¶ 13, 164.) On November 17, 1999 the plaintiffs filed this complaint, (R. 42).

STANDARD OF REVIEW

KPMG's motion to dismiss the plaintiffs' securities fraud complaint implicates the Federal Rules of Civil Procedure 12(b)(6) and 9(b) as well as the PSLRA. Under Rule 12(b)(6), we will dismiss a complaint for failure to state a claim only if "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." See Maple Lanes, Inc. v. Messer, 186 F.3d 823, 824-25 (7th Cir. 1999) (quoting Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 2 L.Ed.2d 80 (1957)). On a motion to dismiss, this Court draws all inferences and resolves all ambiguities in favor of the plaintiffs and assumes that all well-pleaded facts are true. See Long v. Shorebank Dev. Corp., 182 F.3d 548, 554 (7th Cir. 1999) (citation omitted).

Rule 9(b) requires plaintiffs to plead "the circumstances constituting fraud . . . with particularity." In re HealthCare Compare Corp. Sec. Litig., 75 F.3d 276, 281 (7th Cir. 1996). "This means the who, what, when, where, and how: the first paragraph of any newspaper story." DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990). As a policy matter, the heightened pleading requirements under Rule 9(b) serves three main purposes: "to protect defendants' reputations, to prevent fishing expeditions, and to provide adequate notice to defendants of the claims against them." Fugman v. Aprogenex, 961 F. Supp. 1190, 1194 (N.D.Ill. 1997) (citing Vicom, Inc. v. Harbridge Merchant Servs., Inc., 20 F.3d 771, 777 (7th Cir. 1994)).

In addition to the Rule 9(b) requirement, the PSLRA amendments to the Exchange Act raise the pleading standards in securities fraud cases, requiring the plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2). The PSLRA also requires the plaintiffs to "specify each statement alleged to have been misleading, [and] the reason or reasons why the statement is misleading." 15 U.S.C. § 78u-4(b)(1).

With these standards in mind, this Courts takes as true all well-pleaded facts of the complaint, but we will dismiss the claim if it fails to satisfy the heightened ...


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