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ROCKER MANAGEMENT v. LERNOUT & HAUSPIE SPEECH PRODUCTS

June 7, 2005.

ROCKER MANAGEMENT, L.L.C. ET AL., Plaintiffs,
v.
LERNOUT & HAUSPIE SPEECH PRODUCTS N.V. ET AL., Defendants.



The opinion of the court was delivered by: JOHN LIFLAND, Senior District Judge

MEMORANDUM AND ORDER (Lernout, Hauspie, and Bastiaens)

Plaintiffs Rocker Management, LLC, Rocker Partners, LP, Rocker Offshore Management Company, Inc., and Compass Holdings Ltd. (collectively, "Rocker") have asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78j(b), 78t(a), and Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder by the United States Securities and Exchange Commission ("SEC"), against Defendants Jozef Lernout, Pol Hauspie, Gaston Bastiaens, Carl Dammekens, Allan Forsey, Ellen Spooren, Erwin Vandendriessche, Gerald Calabrese,*fn1 Klynveld Peat Marwick Goerdeler Bedrijfsrevisoren (a/k/a KPMG Bedrijfsrevisoren or KPMG Belgium), KPMG International ("KPMG"), KPMG UK, KPMG LLP, Paul Behets, and SG Cowen Securities Corporation ("Cowen") (collectively, "Defendants").*fn2 Plaintiffs also bring state law claims for tortious interference with prospective economic advantage, conspiracy to tortiously interfere, and aiding and abetting tortious interference.

Before the Court are the Motions of individual defendants Jozef Lernout, Pol Hauspie, and Gaston Bastiaens ("Individual Defendants") to dismiss Counts I, II, V, VI, and VII of the First Amended Complaint and Jury Demand for failure to state a claim under Federal Rules of Civil Procedure 12(b)(6), 9(b), and the Private Securities Litigation Reform Act, 15 U.S.C. § 78u-4(b)(1), (2) (the "PSLRA" or "Reform Act").*fn3 For the reasons set forth below, these motions will be denied.

  FACTS

  The facts are taken from Plaintiffs' 315-paragraph, 132-page Amended Complaint. Lernout & Hauspie Speech Products N.V. ("L&H" or "the Company"), formed in 1987 by Jozef Lernout and Pol Hauspie, was a Belgian-American company that specialized in speech recognition, text-to-speech conversion, and digital speech compressions. (Am. Comp. ¶¶ 1, 12). L&H's stock was traded on American and European exchanges. Since its initial public offering in 1995, L&H reported rapid growth in its revenues due to its domination of its software market, its acquisition of other companies, and its development of revolutionary and "industry first" products. (Am. Compl. ¶ 32). Following public announcements in late 1999 and the first quarter of 2000 concerning both its reported revenues and its products, in addition to "strong buy" recommendations from L&H's investment banker, SG Cowen Securities Corporation ("Cowen"), and revenue compilations by its independent auditor, L&H's stock price rose from less than $19 in late November 1999 to a high of $72 in 2000 — upwards of a 300% increase. (Id. ¶¶ 2, 63). The increase in stock price is alleged to be the result of a scheme of fraud and deception on the part of L&H — together with its related capital funds, officers and directors, accountants, and investment bankers. The unveiling of that scheme in the latter half of 2000, due to investigative reporting by the Wall Street Journal, sent the stock price into a tailspin. The exchanges then halted trading in the stock, and L&H sought refuge in bankruptcy proceedings.

  Plaintiffs are hedge funds that, while also purchasing shares of stocks believed to be likely to appreciate, identify and sell short*fn4 shares of stocks that they believe to be likely to decline in price. Beginning in June 1998, Plaintiffs established and built short positions in L&H stock for essentially three reasons: (1) L&H's senior management had a poor track record, having previously run another technology company, Quarterdeck, into the ground based on an aggressive growth-by-acquisition strategy that they appeared to be repeating at L&H — (2) there was a limited market available for L&H's products; and (3) Rocker doubted whether L&H had sound fundamentals for its business. (Id. ¶ 100).

  Plaintiffs charge that Defendants engaged in a scheme to squeeze*fn5 Plaintiffs out of the L&H market by releasing fraudulent information to the market, causing the price of L&H stock to double and triple from the prices at which Plaintiffs had sold short. The inflation of the price of L&H stock squeezed Plaintiffs, forcing them to reduce their net short positions through cover purchases at artificially high prices, resulting in substantial realized losses in the tens of millions of dollars. (Id. ¶ 5).

  A. KPMG Certification of L&H's 1998 Financials

  On April 9, 1999, KPMG Belgium published its Independent Auditor's Report on L&H's financial statements for the year ending December 31, 1998. (Id. ¶ 51). KPMG Belgium allegedly made several false statements in those certified financials. First, financial statements falsely reported L&H's 1998 revenues. KPMG Belgium itself withdrew its own certification in late 2000 and disclosed to the investing public that its financial statements "should not be relied upon." (Id. ¶¶ 4, 123). L&H's Audit Committee later acknowledged that the statements inflated L&H's actual income by nearly $28 million (including by 24% and 23% in the last two quarters of 1998, respectively). Second, KPMG Belgium represented that it conducted an "independent" audit, thereby indicating that it had no financial interest or ties to L&H management. In fact, the KPMG "global account partner" for L&H who was responsible for overseeing the audit, Paul Behets, took a position with an L&H-related entity shortly after overseeing and certifying these falsified financials. (Id. ¶ 267). Third, KPMG Belgium represented that it "conducted [its] audits in accordance with generally accepted auditing standards in the United States." The financials violated many important aspects of United States generally accepted accounting principles ("U.S. GAAP"), involving the backdating of contracts, contracts entered into with related parties, and the existence of side agreements releasing customers of their obligation to pay. (Id. ¶ 209-10). Finally, KPMG Belgium represented that the financials were "free of material misstatement," and that the financials "present fairly, in all material respects, the financial position of Lernout & Hauspie Speech Products, N.V.," when, in fact, they falsely inflated L&H's revenue by almost $28 million. (Id. ¶ 52).

  B. L&H's Press Releases and Cowen's "Strong Buy" Recommendations

  On December 8, 1999, L&H issued a press release claiming that its Internet translation services were to be offered on a Microsoft website. This press release falsely stated that this development represented an endorsement of L&H's translation product by Microsoft. The press release quoted L&H's Chief Executive Officer, Gaston Bastiaens, as stating that "Microsoft's decision to offer our translation services . . . is a powerful statement. . . . [and] emphatic recognition of the outstanding quality, accuracy, and breadth of L&H's translation capabilities." In fact, however, this decision was simply an advertisement for which L&H may have paid, and did not represent any sort of endorsement by Microsoft of L&H's product. Microsoft was actively looking for a buyer for its 7% stake in L&H. It is alleged that the false press release had the intended effect of pumping up the stock price given the power of a Microsoft imprimatur in the software industry: the stock climbed in the 20's in heavy trading following the December 8th press release. (Id. ¶¶ 55-63).

  Later that month, on December 28, 1999, L&H issued a press release proclaiming the financial success of its Korean operation. L&H had previously acquired a Korean company, Bumil (an acquisition on which Cowen consulted and for which KPMG did due diligence), which subsequently operated as L&H's Korean subsidiary. The press release, which again quoted Bastiaens, stated that (1) L&H-Korea had closed "several deals with customers in the telecommunications, enterprise solutions, and embedded technologies markets"; (2) L&H experienced "strong demand" for its products in Asia; and (3) L&H had sold its software products to securities firms such as Hyundai Securities, Samsung Securities, LG Securities, Daishin Securities, Daewoo Securities, and 10 other Asian securities firms. Later disclosures contradicted those claims of success in Asia; many of the companies identified in the press release denied being L&H customers, there was no "strong demand" in Asia, and officials from both Samsung Securities and LG Securities denied ever having made any purchases from L&H. In fact, L&H's own Audit Committee later recommended reversing every single dollar in L&H-Korea revenues because these "customers" and this "strong demand" did not exist. (Id. ¶ 4a-e). L&H's stock continued to trade in the mid-20s through late 1999 and early 2000.

  On January 5, 2000, Cowen issued "strong buy" recommendations to the investing public. (Id. ¶ 69). Among other things, the report repeated that L&H had signed deals with Asian customers (i.e., Hyundai Securities, Samsung Securities, LG Securities, Daishin Securities, and Daewoo Securities). Cowen's recommendation stated that L&H's revenue results were "impressive," rising "from about $100MM in 1997 to our 2000 estimate of slightly over $500MM." It further states that L&H's "impressive" revenues would stop "endless short yammering in 1999." (Id. ¶ 69). Cowen presumably had knowledge to the contrary, given that, in September 1999, it had performed its own independent analysis of, among other things, financial and operating data, internal financial analyses and internal financial forecasts and reports relating to Bumil, as well as L&H financial and operating data provided by L&H to Cowen. (Id. ¶ 70).

  Shortly thereafter, on January 7, 2000, L&H filed a Form F-3 Registration Statement with the SEC for the issuance of $150 million of common stock. This Registration Statement incorporated by reference KPMG Belgium's certification of L&H's 1998 financial statements. (Id. ¶ 4). As indicated by KPMG Belgium's later withdrawal and the Audit Committee restatement, the 1998 revenues were falsely inflated by almost $28 million in improperly-recorded revenue. (Id. ¶ 81).

  On February 7, 2000, L&H issued a press release about a new "industry first" technology demonstrated at a trade conference, i.e., a hand-held dictation device that would allow the "user to `listen' to e-mail summaries as well as fulltext email," and also issue computer commands by voice. In fact, the device was secretly hardwired to a personal computer for the demonstration. (Id. ¶¶ 76-82).

  In early 2000, more press releases issued boasting of L&H's massive increases in revenue. On February 9, 2000, the Company announced a stock split following the reporting of "record" revenues. That release indicated that L&H had revenues of $110 million for the fourth quarter of 1999, a 43.5% increase over fourth quarter 1998 revenue, and revenue of $344 million for the entire year of 1999, an increase of 62.7% over 1998 revenue. (Id. ¶ 91). The following day, another "strong buy" recommendation issued from Cowen stating that L&H realized $110 million in fourth quarter 1999 reported revenue, L&H booked "a record 80 contracts for the quarter," and had a "surge in Asia business." (Id. ¶ 95). The record revenues for 1999 and the supposed surge in Asian business were fabricated. L&H's Audit Committee later recommended the reversal of $182 million in L&H-Korea revenues. (Id. ¶¶ 3, 94d, 125). More than half of the revenue reported by L&H for 1999 was later reversed. (Id. ¶ 94d).

  From December 1999 through March 2000, the price of L&H stock rose to over $70 (split adjusted) — an increase of more than 300% from its early December 1999 trading price. (Id. ¶ 102).

  C. L&H's Falsification of Revenues

  According to L&H's restated results for 1999, L&H earned $169.5 million that year — a decline of 20% from reported revenues of $211.6 million for 1998 and less than half of the $344.2 million L&H originally reported as 1999 revenue. (Id. ¶ 259). Plaintiffs allege that, despite its declining revenues, L&H created the false appearance of "record" revenues in a variety of ways. First, L&H executed a "start-up" customer scam whereby, among other things, investment funds affiliated with L&H would create a "start-up" shell corporation, also often referred to as a "Language Development Company" or "LDC" that would receive an infusion of cash from the investment fund. The start-up would sign a contract to pay L&H a so-called license fee that would then be reported on L&H's books as revenue. To the extent that any money actually changed hands on these start-up deals, the start-up paid L&H cash that originated with the L&H-related investment fund and, thus, the revenue was self-funded. (Id. ¶¶ 85-88). Second, L&H concealed the fact that its 1999 revenue in its traditional markets in Europe and the United States had declined by 20%, while the reported revenue in Asia rose by 1900%. (Id. ¶ 94a). Third, revenues attributed to Koscom ($5-10 million), Hung Chang ($5 million), Hyundai Securities ($5-10 million) and LG Securities were grossly overstated. Other Asian customers were, in reality, L&H-related start-ups providing self-funded revenue, or, like Samsung Securities, were never L&H customers at all. (Id. ¶ 94b-e).

  The massive revenues supposedly realized in Asia were the result of socalled "factoring agreements" with Korean banks. In a typical factoring agreement, a company assigns an account receivable on a customer contract to a bank, and the bank then provides the company with cash equivalent to the amount of the receivable. If the factoring is with recourse, however, the company must repay the cash to the bank if the customer fails to pay the account receivable, and in this situation the factoring agreement is little different from a loan. L&H's factoring agreements were, in fact, with recourse, and L&H would leave the money on deposit with the bank as security. Nevertheless, L&H would recognize these de facto loans on its books as revenue. In this manner, L&H was able to create the illusion of revenue from its contracts with the shell, "start up" customers who were never going to pay L&H. However, when the bank did not receive payment on the account receivable, the bank seized the cash deposit to make itself whole. In this fashion, over $100 million in supposed L&H Korean "revenue" disappeared from the company's bank accounts. (Id. ¶¶ 150-53).

  As revealed by a report commissioned by L&H's own Audit Committee, L&H used the following accounting tricks to improperly record revenue: (1) booking revenue absent a contract; (2) booking revenue when collectibility was in doubt; (3) booking revenue on contingent contracts and/or prior to delivery; and (4) entering into side agreements with ...


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