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Zerger v. Midway Games

October 19, 2009


The opinion of the court was delivered by: Honorable David H. Coar


The lead plaintiffs in this fraud-on-the-market case have brought suit against several executives of Midway Games, Inc. under §§ 10(b) and 20(a) of the Securities Exchange Act of 1934, see 15 U.S.C. §§ 78j(b), 78t(a), and SEC Rule 10b-5, see C.F.R. § 240.10b-5, alleging that the executives artificially inflated the market value of Midway stock by deceiving the public about the company's financial position. While the executives rushed to sell their Midway stock at the trumped-up prices their "scheme" temporarily sustained, the lead plaintiffs and other putative class members purchased it-and lost millions when the market eventually learned the truth. Or so the plaintiffs allege. The defendants have moved to dismiss the Consolidated Amended Class Action Complaint for failure to state a claim under the stringent pleading requirements of the Private Securities Litigation Reform Act of 1995 ("PSLRA"). See 15 U.S.C. § 78u-4(b)(1)-(2). For the reasons stated below, the motion to dismiss is GRANTED.


Andre Pappas and Giancarlo Dimizio ("Plaintiffs") are the lead plaintiffs in this consolidated action against Steven M. Allison, James R. Boyle, Miguel Iribarren, Thomas E. Powell, and David F. Zucker ("Defendants"), all executives of Midway Games, Inc. Plaintiffs purport to represent a class consisting of "all purchasers of the common stock of Midway between August 4, 2005 and May 24, 2005" (the "Class Period"). (Consol. Am. Compl. ¶1.) Between August 29 and November 22, 2005, Pappas purchased a total of 3,300 shares of Midway's common stock; between November 3 and November 23, 2005, Dimizio purchased 4,300 shares. (R. 28, Ex. B at 2.) They voluntarily dismissed their claims against Midway on March 3, 2009, after Midway had filed Chapter 11 bankruptcy on February 13, 2009. (R. 85.)

Midway's Business Model

Midway Games develops and publishes video games. Over the last twenty-plus years, it has published more than 400 video-game titles spanning the home-console, handheld, coin-operated, and PC platforms. (Consol. Am. Compl. ¶2.) Midway focuses its development efforts on creating a large catalog of titles across many of the most popular video-game genres. (Id.) In 2001, Midway's management decided to focus exclusively on the home-console and handheld markets. (Id.) Midway already had titles available on many major platforms in these markets, including Microsoft's Xbox, Nintendo's Game Cube and Game Boy Advance, and Sony's PlayStation 2 and PlayStation Portable. (Id.)

In February 2005, Midway announced its first profitable quarter in five years: for the fourth quarter of 2004, Midway took in $77 million in revenue and posted a net income of $17 million, in large part due to the successful release of the games Mortal Kombat-Deception and Arcade Treasure 2, as well as its ability to control costs. (Id. ¶3.) Midway's continued success would depend upon its ability to deliver new titles across various platforms in a cost-efficient manner; thus, an important objective for Midway in 2005 was "reasonable growth" in its product-development infrastructure, i.e., attracting and retaining some of the highest quality product developers. (Id.) Midway sought to "internally develop[] products due to the favorable profit margin contribution and the ability to leverage . . . products into sequels and derivative products" (Id. ¶5) and repeatedly told the market that "robust internal product development resources will be a critical advantage" to Midway in the future. (Id. ¶6.)

Accordingly, in 2004-2005, Midway increased its in-house product development team from 330 to 650 employees, in part by acquiring competitors in the interactive-entertainment industry. (Id.) Midway acquired Ratbag Holdings Pty. Ltd. in August 2005, and The Pitbull Syndicate in October 2005. (Id.) Keeping its focus on in-house development of titles for home-console and handheld platforms, Midway contracted with outside companies to develop titles for its PC catalog, including Rise & Fall: Civilizations of War, which was to be developed by Stainless Steel Studios. (Id. ¶¶5, 9.)

Failure of Midway's 2005 Strategy

But all was not well with Midway's business model. After posting a successful fourth quarter in 2004, Midway failed to generate any net income in 2005. (Id. ¶4.) Its sustained investment in infrastructure for in-house product development was a significant drain on its capital resources. (Id. ¶7.) In September 2005, Midway had to borrow $75 million to fund dayto-day operations. (Id.) Throughout the Class Period, however, Defendants repeatedly assured the market that Midway had sufficient working capital to fund day-to-day operations and to continue product development. (Id.)

In December 2005, Midway shut down Ratbag-four months after the acquisition that Defendants (Zucker, in particular) had publicly touted as bolstering Midway's capabilities for in-house development of multi-genre action games. (Id. ¶¶8, 38, 40.) Plaintiffs assert that the decision to shut down Ratbag was made in "late October 2005" without specifying any basis at all for their asserted chronology. (Id. ¶38.) Plaintiffs allege that Defendants' true, "undisclosed strategy" was to acquire Ratbag's customer base, not its product developers or its products. (Id.) Midway's management also concluded that it would be more cost-effective to shut down Ratbag than to integrate its computer systems with Midway's. (Id. ¶38.) At the same time, management fired thirty product developers located at Midway's San Diego, California campus. (Id.) On December 16, 2005, Midway announced that it had incurred approximately $13 million in restructuring charges for 2005. (Id. ¶¶8, 38.) These charges were the result of closing down Ratbag and firing the San Diego product developers. (Id.)

In November 2005, Midway cancelled its contract with Stainless Steel for the development of Rise & Fall and brought the project in-house. (Id. ¶¶9, 37.) Since PC games were not a significant part of Midway's business, it had to increase its investment in PC-game development to accommodate the project. (Id. ¶37.) Rise & Fall was also plagued with an abnormally high number of bugs (approximately 1,800) when Midway took over development, and this required Midway to devote additional development resources to fixing them in time for the game's promised release date in June 2006. (Id.) Plaintiffs allege that Defendants "concealed that Midway would be forced to invest millions of dollars of additional internal product development resources for PC-based products between November 2005 and June 2006" as a result of bringing the development of Rise & Fall in-house. (Id. ¶9.)

Defendants' Stock Sales

By closing Ratbag and canceling the Stainless Steel contract, Midway "incurred, and would continue to incur, millions of dollars of incremental costs." (Id. ¶10.) According to Plaintiffs, Defendants knew that these missteps would soon force Midway into a dilutive convertible debt offering in order to raise capital for day-to-day operations. (Id.) And Defendants "took full advantage of this undisclosed reality," selling 782,950 shares of their Midway stock for $15.3 million. (Id.) They sold nearly all of their shares (740,450 shares for $14.7 million) between December 19, 2005 and January 6, 2006. (Id.) By December 29, 2005, when Sumner Redstone clarified his intentions regarding Midway, Defendants had already sold 490,450 shares for $10.3 million. (Id. ¶11.)

Sumner Redstone

Plaintiffs attribute the inflated price of Midway stock and its subsequent "precipitous decline" to the actions of Sumner Redstone, the chairman of Viacom and controlling shareholder of Midway. Redstone had announced, at some point prior to the Class Period, that he was evaluating Midway as a potential acquisition target for Viacom. (Id. ¶12.) At the same time, he started acquiring large blocks of Midway shares in open-market transactions. (Id.) Plaintiffs acknowledge that "[t]he market considered the information regarding Redstone important." (Id. ¶13.) Indeed, on March 1, 2005, Wedbush Morgan Securities opined that Redstone's "massive purchases" had caused Midway's shares to be "somewhat overvalued." (Id.) And on March 23, 2005, Wall Strategies opined that "if Redstone decides that Midway is not a suitable growth vehicle in the years to come, he could dump his shares on the open market, thus depreciating Midway's share price." (Id.) On December 29, 2005, Redstone announced that he had pledged over 33 million of his Midway shares to Sumco, one of his privately held corporations, to collateralize a $425 million personal loan-and that Midway would not be acquired by Viacom. (Id. ¶¶11, 33-35, 48-50.) Midway stock immediately began to lose value "as Redstone's accumulation of Midway stock abruptly halted and market ...

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