United States District Court, Northern District of Illinois, Eastern Division
Fernando Rossy, Individually and on Behalf of all Others Similarly Situated Plaintiff,
Merge Healthcare Inc., Michael W. Ferro, Jr., Jeffery A. Surges, Justin Dearborn and Steven M. Oreskovich, Defendants.
MEMORANDUM OPINION AND ORDER
Elaine E. Bucklo, United States District Judge
Plaintiff is a shareholder of defendant Merge Healthcare Inc., alleging, on behalf of itself and a class of others similarly situated, that Merge and several of its current and former executives committed securities fraud by materially overstating the company’s “subscription backlog, ” a financial metric defendants told investors was a reliable measure of future revenue, and by misrepresenting the effectiveness of the company’s internal controls to ensure the accuracy of its statements. Two motions to dismiss are before me. The first is by defendants Merge, Ferro, Oreskovich, and Dearborn, and the second is by defendant Surges. For the reasons discussed below, the motions are granted.
The following facts are drawn from the allegations in plaintiffs’ Consolidated Amended Complaint (“CAC”), which I assume to be true for present purposes, Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322 (2007) (“Tellabs I”), and, where noted, from other materials properly before me, including Merge’s SEC filings, press releases, analyst reports, and public statements referenced in the CAC.
Defendant Merge is a healthcare information technology company that develops medical imaging, interoperability, and clinical systems for providers and consumers in the healthcare market. The individual defendants are current or former officers or directors of Merge. In May of 2012, Merge announced the creation of two operating groups: Merge Healthcare, dedicated to developing, selling, and implementing medical imaging and clinical solutions for providers, and Merge Data & Analytics (“Merge DNA”), focused on consumer solutions including a subscription-based clinical trials platform called eClinical OS.
The press release announcing these changes informed investors that due to increased client demand for subscription-based offerings, both operating units would transition towards a subscription-based business model and away from a model based on the sale of perpetual license agreements. The company explained that in addition to reporting its financial results in accordance with GAAP, it would use non-GAAP financial measures to report “non-recurring revenue backlog” (which the parties generally refer to as “subscription backlog” or simply “backlog”), defined as “revenue that we anticipate recognizing in future periods from signed customer contracts as of the end of the period presented.” May 7, 2012, Press Release, Def.’s Mot., Exh. 1, at 8. Merge acknowledged that the transition would result in short-term volatility in Merge’s revenues but emphasized that the new model would maximize transparency, predictability and profitability.
The CAC alleges that Merge’s reported subscription revenue backlog “skyrocketed” over the six quarterly periods ending June 30, 2012, through September 30, 2013. But in January of 2014, Merge announced that it was revising the figures it had previously reported for those periods after discovering that a former sales employee in Merge DNA’s eClinical business had falsified the existence or amount of certain customer contracts.
In a press release attached to a Form 8-K Merge filed on January 8, 2014, the company stated that based on the results of management’s internal investigation, Merge’s Board of Directors authorized an independent investigation by outside legal counsel and a forensic accounting firm. That investigation concluded that the former employee had falsified contracts with an apparent value of approximately $5.8 million and $9.4 million in 2012 and 2013, respectively, to “achieve sales quotas and receive additional commissions totaling approximately $250, 000.” January 8, 2014 Press Release, Def.’s Mot., Exh. 9 at 4. According to the press release, the independent investigation “did not find any evidence that other company employees had participated in, or were aware of, this improper conduct.” Id.
According to the CAC, however, defendants committed securities fraud in violation of Sections 10(b) and/or 20(a) of the Securities Exchange Act of 1934 because they knew or should have known that the subscription revenue backlog figures they originally reported were overstated due to the sales employee’s misconduct. Specifically, plaintiff identifies seventeen SEC filings, press releases, and conference calls made during the putative Class Period (August 1, 2012 to January 7, 2014) and alleges that defendants knew or recklessly ignored the risk that each contained materially false and misleading statement about Merge’s subscription revenue backlog (the “Backlog Statements”) and about the adequacy of Merge’s internal controls (the “Controls Certifications”).
Section 10(b) of the Securities Exchange Act of 1934 prohibits the use of manipulation or deception in connection with the purchase or sale of a security, and SEC Rule 10b-5 forbids, among other things, that any person “make any untrue statement of a material fact” in that connection. City of Livonia Employees’ Retirement System and Local 295/Local 851 v. Boeing Co., 711 F.3d 754, 755-56 (7th Cir. 2013). A successful claim under these provisions requires plaintiffs to plead and prove “both the facts constituting the alleged violation, and the facts evidencing scienter, i.e., the defendant’s intention to deceive, manipulate, or defraud.” Tellabs I, 551 U.S. at 313 (internal quotation marks and citation omitted). Defendants’ challenge to the CAC focuses predominantly on the latter requirement.
To show scienter, plaintiffs must establish that the defendant “either knew the statement was false or was reckless in disregarding a substantial risk of its being false.” City of Livonia, 711 F.3d at 756. Recklessness, in this context, means “an extreme departure from the standards of ordinary care…to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.” Id. (ellipses in original) (citing cases).
Section 20(a) of the Exchange Act provides that “[e]very person who, directly or indirectly, controls any person liable under any provision of this title or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person….” 15 U.S.C.
§ 78t(a). To prevail on a section 20(a) claim, a plaintiff must establish a primary violation of section 10(b) and further show that the “control person” 1) actually exercised control over the operations of the entity principally liable, and 2) had the power or ability-regardless of whether it was exercised-to control the specific transaction or activity upon which the primary violation was predicated. Donohoe v. Consolidated Operating & Production Corp., 982 F.2d 1130, 1138 (7th Cir. 1992) (citing Harrison v. Dean Witter Reynolds, Inc., 974 F.2d 873, 880-81 (7th Cir. 1992)). A section 20(a) violation does not require proof of scienter. Jones v. Corus Bankshares, Inc., 701 F.Supp.2d 1014, 1030 (N.D. Ill. 2010). But because a primary violation under section 10(b) and Rule 10b-5 does require scienter, it follows that a plaintiff must establish scienter on the part of at least one controlled defendant to prevail on a claim under section 20(a).
At the pleading stage, plaintiffs must comply not only with the particularity requirements of Rule 9(b), but also with the “[e]xacting pleading requirements” of the Private Securities Litigation Reform Act, 15 U.S.C.
§ 78u-4 (“PSLRA”). Allegations supporting scienter thus must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” City of Livonia, 711 F.3d at 756-57 (original emphasis). This means that, when viewing the complaint as a whole, “a reasonable person would deem the inference of ...