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Washtenaw County Emples. Ret. Sys. v. Avid Tech., Inc.

United States District Court, D. Massachusetts

June 27, 2014

WASHTENAW COUNTY EMPLOYEES RETIREMENT SYSTEM, and MICHAEL COURTNEY, Individually and on Behalf of All Other Persons Similarly Situated, Plaintiffs,

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[Copyrighted Material Omitted]

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[Copyrighted Material Omitted]

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For WASHTENAW COUNTY EMPLOYEES RETIREMENT SYSTEM, Consolidated Plaintiff: David A. Rosenfeld, LEAD ATTORNEY, PRO HAC VICE, Robbins Geller Rudman & Dowd LLP, Melville, NY; Theodore M. Hess-Mahan, LEAD ATTORNEY, Hutchings, Barsamian, Cross and Mandelcorn, LLP, Wellesley Hills, MA; Adam M. Stewart, Shapiro Haber & Urmy LLP, Boston, MA; Jeremy A. Lieberman, Pomerantz Haudek Block Grossman & Gross LLP, New York, NY.

For Michael Courtney, Individually and on Behalf of All Other Persons Similarly Situated, Plaintiff: Jeremy A. Lieberman, LEAD ATTORNEY, PRO HAC VICE, Pomerantz Haudek Block Grossman & Gross LLP, New York, NY; Kathleen M. Donovan-Maher, LEAD ATTORNEY, Berman DeValerio Pease Tabacco Burt & Pucillo, Boston, MA; Adam M. Stewart, Edward F. Haber, Shapiro Haber & Urmy LLP, Boston, MA; Bryan A. Wood, Berman DeValerio, Boston, MA.

For Avid Technology, Inc., Gary G. Greenfield, Kenneth A. Sexton, Defendants: John D. Donovan, Jr., Michael J. Vito, William J. Dunn, Ropes & Gray LLP - MA, Boston, MA.

For Ernst & Young LLP, Defendant: Daniel L. McFadden, Lisa C. Wood, Matthew C. Baltay, Foley Hoag LLP, Boston, MA.

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This is a putative class action filed by Michael Courtney (" Courtney" ) and Washtenaw

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County Employees Retirement System (" Washtenaw" ) (collectively, the " Plaintiffs" ) against Avid Technology, Inc. (" Avid," or the " Company" ), certain of its officers (the " Individual Defendants" ) (collectively with Avid, the " Avid Defendants" ), and Ernst & Young LLP (" Ernst & Young" ) (collectively with the Avid Defendants, the " Defendants" ), seeking remedies for violations of the federal securities laws pursuant to the Securities Exchange Act of 1934, Pub. L. No. 73-291, 48 Stat. 881 (codified as amended at 15 U.S.C. § § 78a-78pp) (the " Exchange Act" ). This securities class action is brought by the Plaintiffs on behalf of purchasers of Avid common stock on the NASDAQ Stock Market (" NASDAQ" ) between October 23, 2008, and March 20, 2013, inclusive (the " Class Period" ).

The Plaintiffs' core contention is tat the Defendants took actions to present false and misleading financial statements, which artificially inflated Avid's stock price. Those actions involved the knowing violation of established accounting principles, the manipulation of accounting reserves, and the withholding of true and essential information regarding the Company's business. As a result, when the truth was revealed to the market, Avid's stock price plummeted.

The present lawsuit is the result of a consolidation of two class actions separately filed by the two Plaintiffs. After the consolidation, the Defendants moved to dismiss the lawsuit under Federal Rule of Civil Procedure 12(b)(6) (" Rule 12(b)(6)" ), attacking the legal sufficiency of the complaint in light of the heightened pleading requirements under the Private Securities Litigation Reform Act, Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.) (the " Reform Act" ), and under Federal Rule of Civil Procedure 9(b) (" Rule 9(b)" ). At a motion session held on February 11, 2014, this Court allowed the motion to dismiss as to the claims of fraud related to the restructuring of the Company and also those related to the European sales operation, and took under advisement the fraud claim pertaining to post-contractual customer support.

A. Procedural Posture

Courtney filed a complaint in this Court on March 25, 2013. Class Action Compl., ECF No. 1. On May 24, 2013, Washtenaw, which had filed a related lawsuit, also in this session of the Court, moved to consolidate these cases, appoint a lead plaintiff, and approve the selection of counsel. Washtenaw Cnty. Emps.' Retirement Sys.'s Mot. Consolidation, Appointment Lead Pl. & Approval Selection Counsel, ECF No. 6. On June 11, 2013, this Court allowed the motion to consolidate and set for hearing the motion to appoint lead counsel. Elec. Order, June 11, 2013, ECF No. 18. At a motion hearing held on July 31, 2013, this Court allowed the stipulation of the parties as to lead counsel and granted the Plaintiffs forty-five days to file a joint complaint. Elec. Clerk's Notes, July 31, 2013, ECF No. 25. The joint amended complaint was filed on September 16, 2013. Am. Compl., ECF No. 26.

On October 31, 2013, the Avid Defendants filed a motion to dismiss accompanied by a supporting memorandum of law. Defs. Avid Tech., Inc., Louis Hernandez, Gary G. Greenfield, & Kenneth A. Sexton's Mot. Dismiss Pls.' Am. Compl., ECF No. 33; Mem. Law Supp. Defs. Avid Tech., Inc., Louis Hernandez, Gary G. Greenfield, & Kenneth A. Sexton's Mot. Dismiss Pls.' Am. Compl. (" Avid's Mem." ), ECF No. 34. On the same day, Ernst & Young also filed a motion to dismiss along a supporting memorandum of law. Ernst & Young LLP's Mot. Dismiss, ECF No. 36; Mem.

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Supp. Ernst & Young LLP's Mot. Dismiss (" Ernst & Young's Mem." ), ECF No. 37. On December 16, 2013, the Plaintiffs opposed both motions to dismiss. Lead Pls.' Mem. Law Opp'n Avid Defs.' Mot. Dismiss (" Pls.' Opp'n Avid" ), ECF No. 44; Lead Pls.' Mem. Law Opp'n Def. Ernst & Young LLP's Mot. Dismiss (" Pls.' Opp'n Ernst & Young" ), ECF No. 46. The Defendants filed their reply briefs on January 22, 2014. Reply Mem. Law Further Supp. Defs. Avid Tech., Inc., Louis Hernandez, Gary G. Greenfield, & Kenneth A. Sexton's Mot. Dismiss Pls.' Am. Compl. (" Avid's Reply" ), ECF No. 50; Ernst & Young LLP's Reply Br. Supp. Mot. Dismiss (" Ernst & Young's Reply" ), ECF No. 51.

At the motion hearing on February 11, 2014, the Court allowed the motion to dismiss as to the claims of fraud related to the Company restructuring and also as to the European sales operation, while taking under advisement the fraud claim pertaining to post-contractual customer support. See Hr'g Tr. 18:12-22, Feb. 11, 2014, ECF No. 57.

B. Facts Alleged[1]

1. Parties

The Plaintiffs purchased Avid's securities at purportedly artificially inflated prices during the Class Period, and they were then damaged because of the price drop after the Company announced the corrective measures. Am. Compl. ¶ 14.

Avid is a Delaware corporation with its principal place of business in Burlington, Massachusetts. Id. ¶ 15. Avid is a leading provider of software systems and hardware products used to create and manipulate digital media content. Id. ¶ ¶ 2, 22. Its products are used by professionals to produce feature films, television programming, live performances, and recorded music. Avid's Mem. 2. Avid's common stock trades on NASDAQ. Am. Compl. ¶ 15.

Gary G. Greenfield (" Greenfield" ) was Avid's Chief Executive Officer (" CEO" ), President, and Chairman of the Board during almost the entire Class Period, having resigned on February 11, 2013, just over a month before the end of the Class Period. See id. ¶ 16. Kenneth A. Sexton (" Sexton" ) was Avid's Chief Financial Officer (" CFO" ), Executive Vice President, and Chief Accounting Officer throughout the entire Class Period. Id. ¶ 17. Louis Hernandez (" Hernandez" ) is the current President and CEO of Avid, and was appointed immediately after Greenfield's resignation. Id. ¶ 114.

Ernst & Young served as Avid's independent registered public accounting firm throughout the Class Period. Id. ¶ 21. Accordingly, " [Ernst & Young] audited and issued unqualified audit opinions on Avid's financial statements and its system of internal controls over financial reporting for the years [2008 through 2011]." Id.

2. Avid's Purported Fraudulent Schemes

The Plaintiffs generally allege that " [t]hroughout the Class Period, [the] Defendants engaged in a wide ranging scheme to materially inflate [Avid's] reported financial statements." Id. ¶ 3. More specifically, the Plaintiffs identify three instances where the fraud took place: (1) Avid recognized revenues generated from software updates " immediately upon the commencement of a licensing

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agreement with a customer, as opposed to ratably over the term of the contract" - the manner provided by the Generally Accepted Accounting Principles (" GAAP" ). Id. ¶ 4. As a result of this accounting tweak, the Company's results were artificially inflated, which were reflected in the stock price, see id.; (2) Avid " manipulated accounting reserves associated with the four restructuring initiatives during the Class Period in order to inflate its earnings, and by extension the stock price," id. ¶ 5 (emphasis omitted); (3) After touting Avid's increasing operating efficiency for many quarterly reports, the Company finally disclosed " that its centralized sales structure in Europe was failing and that its scheme to increase prices in order to offset lost sales was equally ineffective." Id. ¶ 7. As a result of the disclosure, Avid's stock price plummeted. Id. The Plaintiffs further claim that, " during the Class Period, the Individual Defendants engaged in insider trading, improperly benefiting from their financial shenanigans and Avid's artificially inflated stock price, by selling shares of Avid common stock." Id. ¶ 20.

According to the Plaintiffs, the first two events could only have taken place with the " cooperation and imprimatur" of Ernst & Young, who ignored " fundamental accounting principle[s]" and allowed the fraud to occur. Id. ¶ 6. To better understand the issues involved, the Court breaks down the three fraudulent schemes alleged by the Plaintiffs.

a. Improper Recognition of Revenue from Post-Contract Customer Support

The first -- and strongest -- allegation by the Plaintiffs regards Avid's accounting treatment of the revenue originated by post-contract customer support (" PCS" ). Before going over the Plaintiffs' arguments, a brief overview of PCS and its accounting treatment is in order.

" PCS is the right to receive services or unspecified product upgrades or enhancements offered to users or resellers, after the software license begins, or after another time as provided for by the post-contract customer support arrangement." Id. ¶ 25. The purveyance of PCS is a common practice in the software business: besides delivering the software, the producers " provide their customers with other elements such as additional software products, training, installation, consulting, telephone support, and future upgrades or enhancements after the delivery of the initial software." Id. Importantly, " [b]ecause PCS is considered a separate element in a software arrangement," GAAP precludes the recognition of PCS revenue upon the immediate delivery of the software, and " requires that companies record PCS revenue ratably in financial statements over the term of the contract." Id.

The Court makes two distinctions at this point. First, PCS-type services (or " upgrades" ) are distinct from mere " bug fixes." While the former constitute some sort of enhancement to the product,[2] the latter merely fix some coding defect or error. Avid's Mem. 2. As a result, for accounting purposes, there is a substantial difference between PCS and bug fixes: under GAAP, revenue on software sold without PCS -- i.e., with only " bug fixes" supplied after the sale -- is recognized fully upon the sale. See id. at 2-3. Conversely, revenue from software sold with PCS --

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i.e., with enhancements available in the future --is recognized ratably over the life of the period in which the support is offered. See Accounting Standards Codification (" ASC" ) 985-605-25-10 [3]; Avid's Mem. 2-3. In addition, a " pattern[] of regularly providing . . . certain kinds of customers with . . . unspecified upgrades or enhancements" can result in " implied [PCS]," ASC 985-605-25-66, that also triggers ratable revenue recognition over the " implied" support period.

The second distinction regards the accounting of the so-called " multiple element arrangements," where both software and PCS are provided pursuant to separate contractual components.[4] In such cases, the various elements of the contract must be allocated according to GAAP's revenue recognition criteria. See generally ASC 985-605-25-5 to 25-11. For instance, while the software sale and delivery are accounted immediately, the PCS element must be accounted ratably over the term of the contract. See Am. Compl. ¶ 27. The value assessment of each element is " based on vendor subjective objective evidence of fair value." Id. Accordingly, " the fair value of the PCS [is] determined by reference to the price the customer would be required to pay when it is sold separately." Id. If, however, the company is unable to determine the value of the separate elements of the arrangement and the only undelivered element is PCS, revenues for the entire licensing arrangement should be recognized ratably, and not up front. See ASC 905-685-25-70.

According to the Plaintiffs, during the entire Class Period, Avid sold software that included explicit or implied promises to provide software updates, which the Plaintiffs argue was a type of PCS. See Am. Compl. ¶ 24. Accordingly, each and every Avid Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (" SEC" ) since at least 2008 stated that the Company complies with GAAP by deferring the fair value of PCS and recognizing the related revenue ratably over the span of the service period. Id. ¶ ¶ 26-30.

On February 25, 2013, however, based on an internal review of its accounting practices, Avid announced that it would delay the release of its fourth quarter and fiscal year 2012 financial results because " it needed additional time 'to evaluate its current and historical accounting treatment related to bug fixes, upgrades and enhancements to certain products which the Company has provided to certain customers.'" Id. ¶ 116 (quoting Avid Tech. 8-K, issued Feb. 25, 2013).

Subsequently, on March 19, 2013, Avid announced its intent to restate previous financial statements based on its failure " 'to recognize [revenues] ratably over the estimated PCS service period.'" Pls.' Opp'n Avid 4 (alteration in the original). The failure was related to implied PCS that should have been accounted ratably but was instead accounted up front. Am. Compl. ¶ 124 (" The Company expects that the timing of revenue recognition for the impacted customer arrangements will change from the historical presentation in the Company's financial statements pursuant to which revenue was recognized up

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front, generally to being recognized ratably over the estimated implied PCS service period." ) (quoting Avid Tech. 8-K, issued May 17, 2013). According to Avid's disclosure, " the 'primary focus' of the Company's still ongoing review of its accounting treatment for Software Upgrades 'ha[d] been to determine whether no-charge bug fixes previously made available by the Company to its customers included upgrades or enhancements and if so, whether such upgrades or enhancements met the definition of [PCS] under [GAAP]'" . Id. ¶ 141 (first alteration in the original) (quoting Avid Tech. NT 10-K, issued Mar. 19, 2013).

The Plaintiffs allege that the price of Avid's stock dropped as a result of these disclosures. Id. ¶ 140-42, 144.

b. Manipulation of Restructuring Expenses

The second fraud alleged by the Plaintiffs regards the manipulation of expenses incurred with Avid's restructuring. Between 2008 and 2012, the Company went through four restructuring initiatives. Id. 1 35. For each of these initiatives, the company recorded restructuring charges in its quarterly and annual forms. Id.

In 2012, however, Avid announced in its first quarter Form 10-Q that it had identified errors in previous financial statements. Id. ¶ 36, 100. Through the revised financial statements:

[T]he Company increased its 2011 net restructuring costs by $1.3 million (or 14.7%) and reduced its 2010 net restructuring costs by $1.6 million (or 7.7%). The Company increased its first quarter 2011 net recovery of previously expensed restructuring costs by $740,000 (or 33.4%), reduced its second quarter 2011 net recovery of previously expensed restructuring costs by $325,000 (or 199.4%) and increased its fourth quarter 2011 net restructuring costs by $240,000 (or 2.8%).

Id. ¶ 37 (citing Avid Tech. 10-Q, issued May 10, 2012). According to the Plaintiffs, Avid's stock price immediately dropped as a result of this announcement, and " continued to drop precipitously for several days thereafter on heavy trading volume." Id. ¶ 101. Likewise, on May 21, 2013, Avid disclosed it had overstated restructuring expenses related to the second and third quarters of 2012. Id. ¶ 124.

The Plaintiffs claim that the Avid Defendants " used the above restructuring accounting shenanigans to manipulate the Company's earnings by setting up excess reserves in prior periods and then releasing the reserves into earnings in subsequent periods, creating phantom income." Id. ¶ 38.

c. Decline in European Sales Resulting in Restructuring Charges

The third instance of fraud alleged by the Plaintiffs regards the changes made to the European operation of the Company. According to the Plaintiffs, for some period of time since 2008, the Avid Defendants " touted the Company's increasing operating efficiency with respect to its sales force . .., increasing sales revenues, and positive company-wide growth in the prior reporting periods." Id. ¶ 43. On July 21, 2011, however, the Avid Defendants " disclosed that the Company badly missed sales revenues targets they had led investors to expect, revealing for the first time that significant deficiencies in the structure of Avid's European sales force required a restructuring of the entire division." Id. ¶ 41. The disclosure immediately caused a sharp drop in Avid stock price, which traded in unusually high volume the following day. Id. ¶ 87. The Plaintiffs allege that the Avid Defendants made misstatements promoting the Company's efficiency while

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knowing their falsity as to the European operation. ...

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