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United States Securities and Exchange Commission v. Kearns

February 23, 2010


The opinion of the court was delivered by: Brian Kearns Simandle, District Judge



This action is presently before the Court a motion to dismiss by Defendants Brian J. Kearns [Docket Item 15].*fn1 In response to this securities fraud action brought by the United States Securities and Exchange Commission ("SEC"), Defendant Kearns argues that the complaint is untimely and that the SEC fails to state a claim for securities fraud. The Court, for the reasons expressed below, finds that this action was timely commenced and it will deny Defendant's motion to dismiss, except as to any claims arising out of the statements constituting mere "puffery" made during the quarterly meetings and again in various Forms 8-K, because these statements are not actionable misrepresentations under the securities statutes.


A. Factual Allegations

1. MedQuist Billing Scheme

Underlying this action is an alleged fraudulent scheme by Medquist Inc., a medical transcription company based in New Jersey, to improve financial performance by "systematically and secretly inflat[ing] its bills to customers in order to increase revenues and profit margins" from 1999 to 2004. (Compl. ¶ 1.) According to the complaint, MedQuist took advantage of the opaque quality of the billing arrangements in many of its customer contracts, in which the bill was to be calculated by using a unit of measure called an "AAMT line." (Id. ¶¶ 9-10.) The AAMT line was any line of 65 "characters," with characters being functions that were not all visible to a reviewer, so that it was impossible for clients to confirm that they had been correctly billed. (Id. ¶¶ 10-13.) Beginning in 1999, MedQuist began to deviate from the billing method outlined in many contracts, first by ceasing to actually count AAMT lines, but instead calculating AAMT lines by simply multiplying the payroll line count (the measure MedQuist used to pay transcriptionists and not equal to the AAMT line) by two. (Id. ¶¶ 13-16.) This policy was known at MedQuist as "2-to-1 ratio" or the "2-to-1 Bill to Pay [BFP]" ratio. (Id. ¶ 16.) MedQuist adopted a second billing policy, in which clients were billed $3 for every $1 paid to a transcriptionist, known as the "3-to-1 ratio." (Id. ¶ 18.)

"MedQuist continued to secretly adjust line count ratios until 2004 or later," using an internal unit called the Financial Operational Audit ("FOPA") to implement the billing scheme. (Id. ¶ 20.) The FOPA prepared reports that documented the billing strategies and recommended "secretly or gradually" increasing line count ratios and creating AAMT accounts to allow for manipulative billing practices. (Id.) In order to disguise these artificial billing increases, MedQuist would sometimes time the increases to period of heavy work volume, so that the increases would go unnoticed. (Id. ¶ 22.)

2. Defendant Kearns' Knowledge and Participation in MedQuist's Billing Scheme

The SEC alleges that Defendant Kearns, Treasurer and Chief Financial Officer ("CFO") of MedQuist from October 2000 through July 2004, "knew about this billing scheme and, instead of stopping the fraud, took steps to further and conceal the scheme." (Id. ¶¶ 2, 7-8.)

On October 16, 2000, Defendant Kearns joined MedQuist as its Treasurer and CFO, and on October 18, 2000, Defendant Kearns attended a meeting during which the Chief Operating Officer ("COO") "discussed MedQuist's 2-to-1 BTP ratio and the 3-to-1 gross margin policies." (Compl. ¶ 31.) Defendant Kearns' discussions with the COO continued, as did similar discussions with the director of the FOPA, until early 2002, and included talk of "the revenue and gross margin targets established by the 3-to-1 margin ratio policy," the lack of uniformity in application of the 2-to-1 BTP ratio, and the content of FOPA reports. (Id. ¶¶ 32, 34.) In addition, the FOPA director and Defendant Kearns "discussed [MedQuist's] adjustments to ratios to increase line counts and revenue." (Id. ¶ 34.) During this period Defendant Kearns also received reports and emails from FOPA that recommended gradually and secretly increasing the line count ratios to increase profits. (Id. ¶¶ 35-37.) From October 2000 through 2001, Defendant Kearns discussed with Defendant Van Fossen, MedQuist's Controller, "the 2-to-1 BTP ratio policy and the use of ratios instead of counting AAMT lines" and both regularly saw "management reports that presented customer billed AAMT line totals in terms of ratios rather than counts." (Id. ¶ 33.)

3. Defendant Kearns' Failure to Respond to Employee and Customer Complaints Regarding Fraudulent Billing Practices

In February 2003, Defendant Kearns, along with Van Fossen, learned of another employee complaint regarding secret billing adjustments ("I [] was encouraged to and I quote 'play the game' and > there [sic] clients. I was told that 'everyone else does it' . . .") in the Pennsylvania office. (Compl. ¶ 51.) Kearns and Van Fossen directed a review of the office, but the review was ineffective because it did not examine line count accuracy or arrange for audit trails, even though the employee performing the review told Defendant Kearns "that a January 2002 internal FOPA review of the Pennsylvania office had recommended secret changes to line count ratios to increase revenue and profit margins and that line count ratios at that office had in fact been increased without any audit trails or documentary support." (Compl. ¶¶ 51-54.) Van Fossen saw that of all the line ratios at the Pennsylvania office, approximately 37% of customers had ratios higher than 2 to 1. (Id. ¶ 53.) Nevertheless, on February 21, 2003, Defendant Kearns told the Audit Committee of MedQuist's Board of Directors and the external auditors that the review of the Pennsylvania office did not show any billing irregularities. (Id. ¶ 55.)

Again, in March 2003, Kearns learned of an employee complaint about "suspicious billing" in the Ohio MedQuist office. (Id. ¶ 56.) An FOPA report, dated April 3, 2004, stated that the office "routinely changed line count ratios after contracts were in place" to manipulate profit margins and found "multiple control weaknesses, including no record of ratio changes." (Id.) Van Fossen received a copy of this report and Kearns knew of its content. (Id.)

On September 10, 2001, Kearns received a report from a senior staff meeting detailing why customers had left MedQuist for other services. (Compl. ¶ 44; Van Fossen Exh. J.) Sixteen former customers gave reasons for leaving and of those, nine*fn2 complained of a lack of transparency in billing or a billing problem, noting "fraudulent billing practices," "no verification of lines billing; could not justify bills," "could not justify billing," "concerned with inability to reconcile line counts," "pricing and billing issues," "unable to reconcile billing . . . no satisfactory explanation of invoices," "Service and Billing Dispute . . . could not discuss in detail due to pending lawsuit," "billing issues; no justification," and "line counts never matched . . . never a clear explanation of our invoices." (Van Fossen Exh. J.) In March 2002, the COO informed Defendant Kearns that employees were "jockeying [] the bill-to-pay ratio's [sic] to appease customers - only to have [MedQuist] lose the customer eventually anyway." (Compl. ¶ 45; Van Fossen Exh. E.) Finally, that same month, MedQuist's General Counsel told Kearns "that another AAMT line customer had sued MedQuist for $200,000 alleging fraudulent overbilling." (Compl. ¶ 46.)

4. Omissions and Misrepresentations to Auditors

The SEC alleges that from October 2000 to 2004, despite his duty to MedQuist shareholders to ensure the accuracy and integrity of the company's billing and financial reporting, Defendant Kearns did not inform auditors that MedQuist no longer counted AAMT characters, had inadequate controls on its billing process, manipulated line count ratios to increase revenue, was subject to employee and customer complaints of billing fraud. (Id. ¶¶ 62-66.) Kearns did not reveal this material information to auditors, even though he knew these facts or was reckless in not knowing. (Id.)

During the 2002 annual audit, Defendant Kearns permitted a subordinate to give auditors a fabricated document, though Kearns knew it was fabricated, that was designed to convince auditors that MedQuist calculated AAMT lines by counting characters, rather than by using ratios. (Id. ¶ 68.) Kearns knew or was reckless in not knowing that the fabricated document was misleading because it represented a billing method that was not in use. (Id.)

Until the third quarter of 2003, Defendant Kearns signed representation letters to external auditors that falsely stated that he had provided all relevant information to auditors, that he knew of no false statements to auditors, that he knew of no internal control deficiencies, and he knew of no allegations of fraud by employees or others. (Id. ¶ 69.)

As previously noted, on February 21, 2003, Defendant Kearns told the external auditors that the internal review of the Pennsylvania office showed no billing irregularities, without revealing that the office made undocumented increases to line count ratios and lacked audit trails. (Id. ¶ 70.) In December 2003, the external auditors asked MedQuist management for information regarding a vice president's allegations of fraudulent billing practices. (Id. ¶ 71.) From December 2003 "through about March 2004," Defendant Kearns was the principal source of information to the auditors. (Id.) During this period, Defendant Kearns told external auditors that MedQuist had done nothing wrong and that the line counts were legitimate, even though he knew that MedQuist was engaged in the above-described billing scheme. (Id.)

5. Omissions and Misrepresentations to Shareholders and the Public

According to the complaint, Defendant Kearns failed to disclose information that an investor would consider important to his investment decisions with MedQuist, including that the company was no longer counting AAMT lines as required by company contracts, that it had inadequate controls on its billing process, that it had received complaints of billing fraud, and MedQuist's improving financial performance was due in part to manipulation of line count ratios. (Id. ¶ 72.) Defendant Kearns reviewed and signed all financial documents, including the Management and Discussion Analyis ("MD&A") sections of the Forms 10-K and 10-Q, which represented that MedQuist's revenue was "based primarily on contracted rates" and that its improved financial performance was due to legitimate business practices such as increased sales to existing and new customers, acquisitions, or growth in its transcription business generally. (Id. ¶¶ 73-74.) These misrepresentations were incorporated into forms Forms S-8, S-3, and S-3A, prepared by Van Fossen and signed by Kearns. (Id. ¶ 75.) The last of these public statements and reports was filed on November 12, 2003.*fn3 (Kearns Exh. A at 2.)

Defendant Kearns participated in quarterly investor conference calls from the third quarter of 2000 through the second quarter of 2002, in which MedQuist attributed revenue growth to "back to basics management discipline," "disciplined business practice," and the experience and discipline of its management team, without revealing that increased revenues were due in part to manipulation of billed line counts. (Id. ¶ 76-77.) Defendant Van Fossen then incorporated the scripts of these calls into MedQuist's Forms 8-K and Defendant Kearns signed those forms. (Id.)

6. The Billing Scheme is Revealed to the Public

On December 12, 2002, a MedQuist vice president complained that she "and other MedQuist employees have been asked to impose general bill increase to clients as a way of increasing MedQuist's revenue without any basis in the underlying client contracts." (Id. ¶ 48.) Soon after, Defendants Kearns learned of the complaint and conducted a review, but did not examine the accuracy of the line counts or the validity of the line count ratios. (Id. ¶ 49.) Due to her concerns regarding billing practices and MedQuist's failure to properly respond, the vice president refused to sign internal certifications for the fourth quarter of 2002 and the first two quarters of 2003. (Id. ¶ 50.)

In November 2003, MedQuist ordered the vice president to sign internal certifications with her written exceptions. (Id. ΒΆ 59.) In a letter dated November 12, 2003, the vice present explained that "she refused to certify that she knew of no instances of fraud, no violations of law and regulations, no false statements, no material adverse effects on financials, and no violations ...

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