The opinion of the court was delivered by: Wolfson, District Judge
Presently before the Court is the motion of defendants, Intelli-Check, Inc. ("Intelli-Check" or "IDN" or the "Company"), Frank Mandelbaum, Paul Cohen, Edwin Winiarz, and W. Robert Holloway, to dismiss plaintiffs' Second Amended Complaint alleging violations of Sections 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78j(b), Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, and Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a). The Court has jurisdiction over this matter pursuant to 28 U.S.C. §§ 1331 and 1337. For the reasons set forth below, defendants' motion to dismiss is granted, though plaintiffs are given leave to file an amended complaint on certain of the claims as set forth herein.
Plaintiffs, Keith Jones, Daniel Borislow, and the D&K Charitable Foundation, *fn1 seek redress for approximately $2,000,000 in losses incurred when they short sold defendant IDN's stock. Second Amended Complaint at ¶¶ 7, 8. Short selling, as explained by the Third Circuit Court of Appeals,
is accomplished by selling stock which the investor does not yet own; normally this is done by borrowing shares from a broker at an agreed upon fee or rate of interest. At this point the investor's commitment to the buyer of the stock is complete; the buyer has his shares and the short seller his purchase price. The short seller is obligated, however, to buy an equivalent number of shares in order to return the borrowed shares. In theory, the short seller makes this covering purchase using the funds he received from selling the borrowed stock. Herein lies the short seller's potential for profit: if the price of the stock declines after the short sale, he does not need all the funds to make this covering purchase; the short seller then pockets the difference. On the other hand, there is no limit to the short seller's potential loss: if the price of the stock rises, so too does the short seller's loss, and since there is no cap to the stock's price, there is no limitation on the short seller's risk. There is no time limit to this obligation to cover.
Zlotnick v. Tie Communications, 836 F.2d 818, 820 (3d Cir.1988). In other words, a short seller borrows shares from a broker and immediately sells them to a buyer; this transaction is the "short sale." The short seller is obligated to purchase the same number of shares to return to the broker at any later date in the future; this transaction is the "covering purchase." If the stock price drops in the time between the short sale and the covering purchase, the short seller profits. If instead the stock price rises, the short seller suffers a loss.
Defendant IDN manufactures and markets a product known as ID-Check, which enables a retailer to verify driver licenses and other forms of government-issued identification. Second Amended Complaint at ¶¶ 17-18. Believing the price of IDN stock was overvalued, plaintiffs short sold a total of 215,300 shares from February 23, 2001 through September 20, 2001. Id. at ¶ 1. The stock price, however, did not drop as plaintiffs had expected. Rather, the price rose substantially, so much so that plaintiffs lost a total of $2,000,000 when they made their covering purchases from October 18, 2001 through January 3, 2002. Id. Plaintiffs allege that defendants engaged in securities fraud through a series of actions designed to artificially inflate the price of IDN's stock, thereby causing plaintiffs' losses. Id. The individual defendants are sued in their following capacities with the Company: Frank Mandelbaum as Chairman of the Board and Chief Executive Officer; Edwin Winiarz as Chief Financial Officer, Senior Executive Vice President, Treasurer and director; W. Robert Holloway as Senior Executive Vice President; and Paul Cohen as director. Id. at ¶¶ 12-15.
A. Plaintiffs' Decision to Short Sell IDN's Stock
Plaintiffs allege that the reason they decided to short sell IDN's stock was because they noticed in IDN's filings with the SEC that for the first and second quarters of 2001, the Company's reported revenues came largely from previous sales instead of new sales. Second Amended Complaint at ¶¶ 28-41. Under IDN's new policy of "deferred revenue recognition," revenues from sales in the fourth quarter of 2000 would be recognized ratably over the following year. Id. at ¶ 29. This was possible because after IDN's sale of its product to a customer, it provided the customer with post-contract service and support. See id. Up until the start of the fourth quarter 2000, IDN recognized all of its revenue at the time the product was sold; the Company thereafter changed its policy by recognizing revenue ratably over the course of the one-year period following the sale. See id. Defendants analogize the difference between the revenue recognition policies to magazine subscriptions: a publisher could recognize revenue of a one-year subscription at the time the sale is made, or ratably over the course of the year when each month's magazine is delivered. Memorandum of Law in Support of Defendants' Motion to Dismiss the Second Amended Complaint ("Def. Br.") at 12 n.6.
Plaintiffs believed IDN's newly-adopted revenue recognition policy gave the false impression that IDN's sales were increasing when in fact they were, at some points, decreasing. For example, as described in more detail below, IDN reported in a press release that its first quarter 2001 revenues were $204,635, compared with $30,218 for the first quarter 2000. Second Amended Complaint at ¶ 33. Plaintiffs considered this misleading because (as IDN disclosed in its 10-QSB for the first quarter 2001) $180,984 of that revenue included revenue that was deferred from previous sales. Id. at ¶ 31. Thus, sales had actually decreased $23,651 from the first quarter of 2000 to the first quarter of 2001. See id. Plaintiffs considered this a misleading accounting technique that artificially inflated the price of IDN's stock. Id. at ¶ 40. They "believ[ed] that eventually IDN would not be able to rely on the use [of] deferred revenues" to overstate the Company's growth, and that the stock price would in time drop as other investors realized it was overvalued. See id. at ¶ 41. According to plaintiffs, this was the reason they decided to short sell IDN's stock. Id.
Plaintiffs allege that they came to the conclusion that IDN was using a misleading accounting technique by analyzing the following three filings with the Securities and Exchange Commission ("SEC") and two press releases: Form 10-KSB for the period ended December 31, 2000 (filed March 31, 2001 and amended October 9, 2001); the May 9, 2001 press release; Form 10-QSB for the period ended March 31, 2001 (filed May 14, 2001 and amended on August 23, 2001); Form 10-QSB for the period ended June 30, 2001 (filed August 13, 2001); and the August 13, 2001 press release. These documents are discussed in turn below.
1. Form 10-KSB for the Period Ended December 31, 2000
IDN filed its Form 10-KSB for the period ended December 31, 2000 on March 31, 2001, and amended it on October 9, 2001. As plaintiffs allege, this filing announced IDN's new revenue recognition policy:
Revenue on sales of the Company's product is recognized upon shipment to the customer. Certain sales require continuing service or post contract customer support and performance by the Company, and accordingly a portion of the revenue is deferred and recognized ratably over the period in which the future service, support and performance are provided, which is generally one year. Currently, if the Company does not have enough experience to identify the fair value of each element, the full amount of the revenue and related gross margin is deferred and recognized ratably over the one-year period in which the future service, support and performance are provided.
...Revenues of $517,950 from sales in the fourth quarter of 2000, as well as cost of revenues of $299,040, were deferred in accordance with the Securities and Exchange Commission's Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements." The deferred revenue and the related cost of revenue will be recognized ratably over a 12 month period....
Second Amended Complaint at ¶ 29. Plaintiffs do not allege that this filing contained any misleading information.
2. May 9, 2001 Press Release
On May 9, 2001, five days before IDN filed its 10-QSB for the first quarter of 2001, it issued a press release highlighting the results of the quarter. The press release stated:
INTELLI-CHECK, INC. (AMEX IDN), *fn2 a developer of advanced document verification systems, announced today financial results for the first quarter ended March 31, 2001, with revenues increasing to $204,635 compared with $30,218 for the first quarter of 2000.
Id. at ¶ 33. In the release, Defendant Frank Mandelbaum, Chairman and CEO of IDN, was quoted as saying:
This is the second consecutive quarter that Intelli-Check has reported significant increases in revenues for its state-of- the-art ID-Check unit...During the first quarter of 2001, Intelli-Check shifted its marketing focus to national accounts, which are expected to contribute to further growth during the remainder of the fiscal year....
Id. Plaintiffs allege these statements were misleading because sales actually decreased from the first quarter of 2000 to the first quarter of 2001. *fn3 Id.
3. Form 10-QSB for the Period Ended March 31, 2001
IDN filed its Form 10-QSB for the period ended March 31, 2001 on May 14, 2001, and amended it on August 23, 2001. This filing listed the same figures announced in the May 9, 2001 press release. See id. at ¶ 31. It stated, in relevant part: "[r]evenues increased substantially from $30,218 for the first three months ended March 31, 2000 to $204,638 recorded for the three months ended March 31, 2001." Declaration of Francis P. Karam in Support of Defendants' Motion to Dismiss ("Karam Dec.") at Ex. D, p. 5. *fn4 As defendants point out, the same paragraph states:
...Revenues for the period ended March 31, 2001 includes [sic] $180,984 of sales deferred during the prior 12 month period. Sales for the period was [sic] minimal due to the recent refocus of our marketing efforts towards the larger retail market, in which the sales cycle requires an extended time frame involving multiple meetings, presentations and a test period. In addition, the roll-out of Sensormatic's sales and marketing initiatives first began in April 2001.
Id. In the same filing, IDN again reported its revenue recognition policy, using substantially the same language as in its 10-KSB for the period ended December 31, 2000. Compare id. at p. 3 with Second Amended Complaint at ¶ 29. Plaintiffs allege that this filing materially misrepresented IDN's performance during the first quarter of 2001. See Second Amended Complaint at ¶ 31.
4. Form 10-QSB for the Period Ended June 30, 2001
On or about August 13, 2001, IDN filed its Form 10-QSB for the period ended June 30, 2001. In relevant part, it stated:
Comparison of the six months ended June 30, 2001 to the six months ended June 30, 2000.
Revenues increased substantially from $47,320 for the six months ended June 30, 2000 to $474,846 recorded for the six months ended June 30, 2001. Revenues from distributors totaled $416,009 and revenues from direct customers totaled $58,837. Revenues for the period ended June 30, 2000 included initial sales of a limited number of ID-Check terminals prior to the early return of our inventory of these terminals to the manufacturer for upgrading. Revenues for the six months ended June 30, 2001 includes [sic] $219,625 of sales deferred during the prior 12-month period. Sales for the period ended June 30, 2001 were limited by the recent refocus of our marketing efforts towards the larger customers within the retail market, in which the sales cycle normally requires an extended time frame involving multiple meetings, presentations and a test period, which has been further extended by the rapid slowing of the economy, whereby decisions for capital expenditures are being delayed. In addition, the roll-out of Sensormatic's sales and marketing initiatives first began in April 2001.
Second Amended Complaint at ¶ 36. This filing also described IDN's revenue recognition policy. Karan Dec. at Ex. F, p. 3. Plaintiffs allege that this filing materially misrepresented IDN's performance during the second quarter of 2001. Second Amended Complaint at ¶ 34.
5. The August 31, 2001 Press Release
On the same day IDN filed its second quarter 2001 10-QSB, it issued a press release announcing the results. The release stated, in relevant part:
INTELLI-CHECK, INC. (AMEX IDN), a developer of advanced document verification systems, announced today financial results for the second quarter ended June 30, 2001, with significant revenue increases for the quarter and six month period.
Revenues for the second quarter of 2001 increased nearly 15- fold to $270,211 compared with $17,102 for the second quarter of 2000. For the first six months of 2001, revenues rose to $474,846, a 10-fold increase, when compared with $47,320 for the year-ago period.
Second Amended Complaint at ¶ 37. Defendant Mandelbaum was quoted as saying:
Intelli-Check reported significant revenue gains even though the roll-out of our advanced ID-Check unit by our major distributor did not occur until well into the second quarter....Our refocused marketing efforts on the larger mass market retailers requires a sales cycle with an extended time frame involving multiple meetings, presentations and test periods, which have been further extended by current economic conditions. To date, we have already sold ID-Check units to some of the largest companies in the gaming industry and have begun to place test units in some of the largest pharmacy and grocery chains, as well as with a large tobacco company. As part of a new marketing effort, we have also begun discussions with original equipment manufacturers to license our technology for inclusion on their platforms. Additionally, we recently released our C-Link software product, which when used with our ID-Check unit enhances a retailer's ability to prevent economic loss from fraudulent transactions. We are confident that these efforts together with our past marketing focus should result in future growth.
Id. at ¶ 38. Plaintiffs allege that this press release materially misstated IDN's growth during the second quarter of 2001. Id. at ¶ 39.
B. IDN's "Squeeze" of Plaintiffs and the Resultant "Bubble Period"
Plaintiffs allege that in the summer of 2001, IDN became aware that plaintiffs had taken significant short positions in its stock. Id. at ¶ 42. Because substantial short sales in a stock can have the effect of lowering the stock price, defendants allegedly set out on a plan to punish or "squeeze" plaintiffs by:
(a) failing to disclose material information that would cause IDN's stock price to drop; and
(b) suppressing the supply of IDN's stock available to be sold.
Id. According to plaintiffs, "the effect of these two strategies was to balloon the overvaluation into a huge, artificial bubble" stretching from late September 2001 until the filing of the Second Amended Complaint on May 31, 2002. Id. The allegedly improper acts of defendants are discussed in turn below.
1. Comparison of Prior Period "Sales" with Current Period "Revenues": Form 10-QSB for the Period Ended September 30, 2001
On November 13, 2001, IDN filed its Form 10-QSB for the period ended September 30, 2001. Id. at ¶ 53. As in the first and second quarter 2001 reports, the third quarter 2001 report announced an increase in revenue as compared to the same period in 2000: "[r]evenues increased $170,590 from $109,676 recorded for the three months ended September 30, 2000 to $280,266 recorded for the three months ended September 30, 2001." IDN's Third Quarter 2001 10-QSB, p. 7. *fn5 This filing also contained an explanation of the revenue recognition policy, id. at 3, but did not specify an amount of current revenues that had been deferred from previous sales, id. at 7. Plaintiffs allege that IDN, through its third quarter 2001 filing, "suggest[ed], wrongfully, that it was continuing to experience sales growth." Second Amended Complaint at ¶ 50.
2. Failure to Disclose Competition
Plaintiffs allege that IDN has never disclosed the existence of competition by VeriFone, a company that markets an identification verification product substantially similar to IDN's. Id. at ¶¶ 43-46. Plaintiffs contend that VeriFone has a unique advantage in the identification verification market because its technology can coexist on terminals that it has already provided to the global market. Id. at ¶ 45. As VeriFone's website explains:
VeriFone's Easy ID application enables merchants to conduct automatic age verification-right from their VeriFone point-of- sale terminal. Easy ID provides a helpful tool to enhance a merchant's overall program to prevent the sale of alcohol, tobacco and other age-restricted items to minors....
Easy ID runs in VeriFone's Verix multi-application environment, meaning it can securely co-exist on the same terminal with payment and other applications.
Verix terminals with Verix Multi-app Conductor can automatically launch Easy ID when a customer's state-issued identification is swiped or scanned.
VeriFone first publicized its Easy ID product in a press release June 20, 2001. Id. at ¶ 44. Since then, IDN has not named VeriFone as a competitor in any of its public filings or statements. Id. at ¶ 46.
3. Untimely and Misleading Disclosure of the Messina Lawsuit
Kevin Messina, a former officer and director of IDN, *fn6 filed a lawsuit on October 19, 2001, against the Company seeking a preliminary injunction enjoining it from restricting sales of his shares of company stock. As discussed more fully in the successive section, Messina alleged that on October 12, 15, and 16, 2001, IDN improperly prevented him from selling significant blocks of his IDN stock. Second Amended Complaint at ¶ 57. On November 13, 2001, in IDN's third quarter 2001 10-QSB, IDN reported that:
On October 19, 2001, a former officer and director of the Company filed a lawsuit against the Company to force the Company to permit him to sell his restricted shares. The complaint also seeks damages of $29,350 for miscellaneous compensation and punitive damages of $3,000,000. The Company considers this former officer an "insider" subject to the rules under Section 144 of the Securities and Exchange Act of 1934. The Company feels it is acting properly and will defend itself vigorously. In addition, the Company intends to file a counter claim.
IDN's Third Quarter 2001 10-QSB, p. 9.
While plaintiffs' complaint is not a model of clarity with respect to the claims of improper disclosure of the Messina suit, the Court can discern four distinct allegations of impropriety:
i) the disclosure was late; that is, IDN should have informed the public about the suit at some point prior to November 13, 2001, see Second Amended Complaint at ¶ 52 and Plaintiffs' Memorandum of Law in Opposition to Defendants' Motion to Dismiss the Second Amended Complaint ("Pl. Br.") at 17;
ii) the disclosure was misleading because it was "inaccurate," see Second Amended Complaint at ¶ 53;
iii) the disclosure was misleading because it failed to specify the allegations of the dispute, see id. at ¶ 52; and
iv) the disclosure was misleading because it did not reveal that Messina refused to cooperate with IDN in a separate patent lawsuit, see id. at ¶¶ 53-54.
The patent suit was filed against IDN in August 1999 by IdentiScan, a rival company which markets a product similar to IDN's. Karam Dec. at Ex. C, p. 10. As reported in IDN's Year 2000 10-KSB, the suit involved a dispute over which company held patent rights to the identification verification technology. Id. IDN's counsel in that suit identified Messina's "input on both our defensive case and affirmative claims against Identi-Scan as critical." Second Amended Complaint at ¶ 53. Yet on July 10, 2001, IDN's patent counsel informed the Company in writing that he had "endeavored unsuccessfully to obtain Mr. Messina's assistance" in the patent litigation. Id. Plaintiffs allege that because the patent was so important to IDN's business, and because Messina's input was critical to IDN's success in the suit, IDN should have disclosed that Messina did not intend to cooperate. Id. at ¶¶ 53-54.
4. IDN's Block of Messina's Sales of His Company Stock
In addition to alleging that IDN improperly disclosed the details of the Messina suit, plaintiffs claim that IDN's actions that precipitated the suit - namely, the Company's refusal to allow Messina to sell his shares on October 12, 15, and 16, 2001 - amount to securities fraud. Id. at ¶¶ 56-58. Plaintiffs contend IDN blocked Messina's sales in order to create a "false shortage" of IDN's shares, which in turn would artificially inflate the stock price. Id. at ¶ 58. Plaintiffs argue this effect on the market is shown by the fact that "IDN's share price has consistently dropped following Messina's sales on January 10, 2002, April 19, 2002, and May 7, 2002." Id.
On September 21, 2001, IDN filed a Registration Statement with the SEC announcing a rights offering for 970,076 of its shares, whereby its stockholders were to receive one non-transferable right to purchase one share of IDN's common stock at $8.50 a share for every ten outstanding shares of common stock held on March 30, 2001. Id. at ¶ 60. On October 5, 2001, IDN issued a press release publicizing the rights offering, which expired on October 4, 2002. Id. at ¶ 62. Plaintiffs allege that the rights offering harmed them because it had "the effect of increasing the cost to cover their short positions." Id. at ¶ 63. In addition, plaintiffs contend that IDN's Prospectus filed in connection with the rights offering incorporated by reference its Year 2000 10-KSB, and its first and second quarter 2001 10-QSBs, which included material misrepresentations concerning the overstatement of revenue and the failure to properly disclose the existence of VeriFone and the details of the Messina suit, as discussed above. *fn7 Id. at ¶ 61.
6. Interference with Borislow's Trading Activities
Plaintiffs dedicate only one paragraph in their Second Amended Complaint to this claim. The paragraph, in its entirety, is as follows:
In addition to the improper activities alleged above, defendants directly or through their legal counsel have interfered with plaintiff's relationship with plaintiff's stock broker, caused an investigation by the SEC into plaintiff's trading activities, attempted to interfere with efforts by plaintiff's [sic] to cover their short positions and otherwise targeted plaintiffs in order to adversely impact their short positions.
Plaintiff Keith Jones originally filed this suit as a class action on October 18, 2001. On November 30, 2001, plaintiff Daniel Borislow joined Jones in filing an amended complaint, which abandoned the class action. Defendant Kevin Messina and the remaining defendants filed, pursuant to Appendix N of the Local Rules of Civil Procedure, two separate Notices of Intent to submit a motion to dismiss the amended complaint on March 11, 2002. Before the Appendix N packages were submitted to the Court, plaintiffs obtained new counsel, and the parties stipulated that defendants would withdraw their motions to dismiss and plaintiffs would file a Second Amended Complaint. On May 31, 2002, plaintiffs Jones and Borislow, along with a new plaintiff, D&K Charitable Foundation, filed their Second Amended Complaint. Plaintiffs voluntarily dismissed their claims against Messina on September 25, 2002, and on October 2, 2002, the remaining defendants filed the present motion to dismiss the Second Amended Complaint pursuant to Fed. R. Civ. P. 12(b)(6) and Fed. R. Civ. P. 9(b). This matter was reassigned from the Honorable Jerome B. Simandle to me on January 8, 2003.
III. APPLICABLE STANDARDS
A. Federal Rule of Civil Procedure 12(b)(6)
Federal Rule of Civil Procedure 12(b)(6) provides that a court may dismiss a complaint "for failure to state a claim upon which relief can be granted." A claim should be dismissed 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." In re: Rockefeller Center Properties, Inc. Securities Litig., 311 F.3d 198, 215 (3d Cir. 2002) (citing Conley v. Gibson, 355 U.S. 41, 45-46 (1957)). The inquiry is not whether plaintiff will ultimately prevail, but whether he is entitled to offer evidence to support his claims. Id. (citing Scheuer v. Rhodes, 416 U.S. 232, 236 (1974)). In deciding a 12(b)(6) motion, courts must accept all well-pleaded factual allegations in the complaint as true and draw all reasonable inferences in favor of the plaintiff. Id. (citing Scheuer, 416 U.S. at 236). Nevertheless, courts are not required to credit bald assertions or legal conclusions alleged in the complaint. Id. (citing In re Burlington Coat Factory Securities Litig., 114 F.3d 1410, 1429 (3d Cir. 1997)). Similarly, legal conclusions draped in the guise of factual allegations do not benefit from the presumption of truthfulness. Id. (citing In re: Nice Systems, Ltd. Securities Litig., 135 F. Supp. 2d 551, 565 (D. N.J. 2001)).
As a general matter, courts ruling on a motion to dismiss may not consider matters extraneous to the complaint. Burlington Coat Factory, 114 F.3d at 1426. However, an exception to the general rule is that a "document integral to or explicitly relied upon in the complaint" may be considered "without converting the motion [to dismiss] into one for summary judgment." Id. (quoting Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1220 (1st Cir. 1996) and citing Trump Casino, 7 F.3d at 368 n.9 ("a court may consider an undisputedly authentic document that a defendant attaches as an exhibit to a motion to dismiss if the plaintiff's claims are based on the document.")). The rationale underlying this exception is that the primary problem raised by considering documents outside the complaint - lack of notice to the plaintiff - is dissipated where plaintiff has actual notice and has relied upon the documents in framing the complaint. ...