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Stevens v. Inphonic

October 14, 2009

THOMAS STEVENS, ET AL., PLAINTIFFS,
v.
INPHONIC, INC., ET AL., DEFENDANTS.



The opinion of the court was delivered by: Reggie B. Walton United States District Judge

MEMORANDUM OPINION

On May 5, 2008, the plaintiffs, purchasers of common stock from InPhonic, Inc. ("InPhonic"), filed their First Amended Class Action Complaint ("Am. Compl.") alleging that between May 8, 2006, and October 11, 2007 (the "Class Period"), Am. Compl. ¶ 1, the defendants, David A. Steinberg ("Steinberg"), InPhonic's Chief Executive Officer ("CEO") and Chairman of the Board of Directors, and Lawrence S. Winkler ("Winkler"), InPhonic's Chief Financial Officer ("CFO") and Treasurer, violated §§ 10(b) and 20(a) of the Securities Exchange Act of 1934 (15 U.S.C. §§ 78j(b), 78t(a) (2006)) and Rule 10b-5 of the Code of Federal Regulations, 17 C.F.R. § 240.10b-5 (2009), Am. Compl. ¶¶ 26-27. Specifically, the plaintiffs contend that the defendants committed these violations by "knowingly and recklessly" artificially inflating InPhonic's stock price by overstating of the company's revenues and understating its expenses related to wireless activations, as well as equipment and consumer rebates for fiscal year 2006. Id. ¶ 4. Currently before the Court is the defendants' Motion to Dismiss the First Amended Class Action Complaint ("Defs.' Mot.") under Federal Rule of Civil Procedure 12(b)(6) for "failure to state a claim upon which relief can be granted," Fed. R. Civ. P. 12(b)(6), which the lead plaintiff opposes.*fn1 For the reasons that follow, the Court must deny in part and grant it in part the defendants' motion to dismiss.

I. FACTUAL BACKGROUND

The facts when considered in the light most favorable to the plaintiffs are as follows. InPhonic is a Delaware corporation with its principal place of business in Washington, D.C. Am. Compl. ¶ 29. InPhonic began operations in 1999, providing a variety of wireless-related services. Id. ¶ 30. Chief among these services was the online sale of wireless service plans and equipment, which comprised 96% of the company's business. Id. InPhonic eventually became the leading seller of cell phones and wireless plans purchased on the Internet. Id. In fiscal year 2006, InPhonic's quarterly filings with the United States Securities and Exchange Commission ("SEC") reported a steady growth in revenue. Id. ¶¶ 52, 71, 102, 132. As required by the Sarbanes-Oxley Act of 2002 ("Act"), 15 U.S.C. § 7241 (2006), defendants Steinberg and Winkler certified the accuracy these filings, including the reported financial results and efficacy of the company's internal controls, as required by the Act. Id. ¶ 84.

On November 7, 2006, while InPhonic's stock price was artificially inflated due to accounting irregularities that were later identified, Steinberg sold 450,000 shares of his InPhonic stock, which amounted to less than 10% of his total holdings, for a total profit to him of $4,702,500. Id. ¶¶ 223-24. On that same date, Winkler sold 100,000 shares of his InPhonic stock, which amounted to about 28% of his total holdings, for a total profit to him of $1,044,999. Id. ¶¶ 240-41. The shares were sold at "a price discounted to market" and 27% below the class-period high. Defs.' Mem., Becker Decl., Ex. Y (Nov. 7, 2006 Form 8-K); see also id. at 15. These sales were made as part of an agreement with Goldman Sachs and other lenders, in exchange for a $100 million line of credit provided to InPhonic. Am. Compl. ¶¶ 225-26.

On April 3, 2007, InPhonic issued a public statement and a SEC Form 8-K filing which revealed that accounting irregularities had resulted in improper revenue recognition for fiscal year 2006. Id. ¶¶ 5, 144. The April 3 filing warned investors that as a result of the accounting errors, the financial statements for the second, third, and fourth quarters of 2006 could no longer be relied upon and also identified three material weaknesses in the company's internal controls. Id. ¶ 144. InPhonic further disclosed the extent of these errors on May 4, 2007, in a Form 8-K/A filed with the SEC. Id. ¶ 147. The May 4 filing clarified that no financial results from 2006 should be relied upon due to numerous misapplications of Generally Accepted Accounting Principles (hereinafter simply "accounting"), including "improperly recognized revenue and improperly deferred expenses; inadequate [internal] controls[,] and insufficient processes, procedures and expertise." Id. Following the April 3 and May 4 filings, InPhonic's stocks fell a total of 19.2 %, id. ¶¶ 200, 203, and on May 31, 2007, defendant Winkler resigned from his position with InPhonic, id. ¶ 27; Defs.' Mem., Becker Decl., Ex. C (May 30, 2007 Form 8-K).

The revenue recognition inconsistency arose because during fiscal year 2006, InPhonic reported that it recognized revenue from carrier commissions*fn2 when the devices were activated and shipped to customers, and then reduced its revenue by subtracting expenses from projected deactivations within a certain period of time, "such as 180 days." Am. Compl. ¶ 34. In a restatement of earnings filed on June 1, 2007 ("June 2007 Restatement"), InPhonic revealed that it had overstated its revenue for 2006 by $34.8 million due to what turned out to be an underestimation of its deactivation projections.

Id. ¶ 35. InPhonic also admitted that it "overstated accounts receivable by using a methodology that anticipated future improvements in collections beyond that supported by past experience, and which did not consider certain current factors and other information." Id. ¶¶ 36, 143. In sum, the June 2007 Restatement indicate that the total revenues for fiscal year 2006 were $369.6 million, down from InPhonic's original $405.7 million in stated earnings, and also that the net losses for 2006 were $63.7 million, $46.4 million more than originally reported. Id. ¶¶ 151-52. noted

In the June 2007 Restatement, InPhonic also stated that the company overstated its equipment revenues by an additional $2.6 million due to the improper recording of uncollected fees and penalties as a result of early termination of wireless plans and wireless devices not returned by customers as required by their sales contracts. Id. ¶¶ 37-38. InPhonic explained that it had presumed in its previous filings that collection percentages of these fees and penalties would increase over past collection rates, but that this increase had failed to occur. Id. ¶ 38. Additionally, InPhonic also stated that it had improperly recorded $2.8 million in revenues as a result of its inaccurate projections of collections on disputed carrier commissions and overstated $4.9 million in equipment revenue due to the improper denial of consumer rebates.*fn3 Id. ¶¶ 39-42.

The June 2007 Restatement also disclosed the existence of internal control deficiencies, or "material weaknesses," including failures to: "maintain sufficient staffing of operational and financial resources;" "effectively communicate information to [InPhonic's] finance department;" "maintain effective controls over the recordation, accuracy and completeness of activations and services revenue and related accounts receivable;" "maintain effective controls over the determination and accuracy of equipment revenue and related accounts receivable;" "maintain effective controls over the accuracy and completeness of consumer product rebate liabilities;" and "maintain effective controls over the accuracy and completeness of costs of goods sold and amounts due from vendors." Id. ¶ 143.

Also on June 1, 2007, following the issuance of the June 2007 Restatement, Steinberg participated in a telephone conference with InPhonic's stakeholders, during which he personally apologized for the need to make financial restatements, and attributed the accounting irregularities to "back office processes [that] have not appropriately scaled with the rapid transaction growth" of InPhonic's business. Id. ¶¶ 152-53, 155. Steinberg also stated during the telephone call that he expected revenues to be between $460 million and $480 million for fiscal year 2007. Id. ¶¶ 157-58. After the call, InPhonic's share price rose 9% at the close of the day's trading on June 1, 2007. Id. ¶¶ 159, 204.

On August 9, 2007, the defendants filed another Form 8-K and a press release announcing that InPhonic had formed a letter of intent with Brightstar, Inc. ("Brightstar"), a "global leader in customized distribution and supply chain solutions for the wireless industry." Id. ¶¶ 165, 171. InPhonic "emphasized the importance of a definitive agreement with Brightstar[,] noting that [the] agreement would... provide [it] benefits in three key areas -- improved cash flows due to outsourced inventory management, enhanced margins resulting from hardware procurement and significant growth opportunities in a new marketing relationship with Brightstar." Id. ¶ 166. The August 9 press release went on to report that Brightstar "strengthened its commitment to this new alliance further by making an investment of approximately $5 million in InPhonic through the purchase of approximately 925,000 newly issued restricted shares."*fn4 Id. ¶ 167. At the close of trading on August 9, 2007, InPhonic's share price increased by 22%. Id. ¶ 205. The following day, August 10, 2007, InPhonic filed a Form 8-K/A that further disclosed details of the improper accounting practices which led to the issuance of the June 2007 Restatement for the fiscal year 2006. Id. ¶ 169. That day, the closing price of InPhonic's shares decreased by nearly 28%. Id. ¶ 206.

On September 5, 2007, InPhonic issued a press release entitled "Brightstar and InPhonic Sign Definitive Agreement to Form Strategic Alliance." Id. ¶ 171. That document outlined "four principle components" of the relationship between InPhonic and Brightstar, including Brightstar's $5 million investment to be paid to InPhonic "subject only to unspecified closing conditions." Id. InPhonic later issued a press release and a Form 8-K on October 11 and October 12, 2007, respectively, announcing that the "proposed" partnership with Brightstar had been "terminated." Id. ¶¶ 175-76. Upon this announcement, InPhonic's stock price dropped from $1.94 to $0.77, a 60% decrease. Id.

¶ 178. Defendant Steinberg subsequently tendered his resignation on November 7, 2007, and on November 8, 2007, InPhonic filed a petition for bankruptcy. Id. ¶ 179.

The plaintiffs have filed this action seeking compensatory damages for losses sustained as a result of the defendants' alleged wrongdoing. Id. ¶ 20. Specifically, the plaintiffs allege that the defendants made fraudulent misstatements in InPhonic's 2006 financial reports, its June 2007 Restatement, its alliance agreement with Brightstar, and the $5 million investment Brightstar was supposed to make in InPhonic. Id. ¶¶ 5, 11, 16.

II. STANDARD OF REVIEW

Federal Rule of Civil Procedure 9(b) requires a plaintiff to "state with particularity the circumstances constituting fraud or mistake." Fed. R. Civ. P. 9(b). The complaint must therefore provide a defendant with notice of "the 'who, what, when, where, and how' with respect to the circumstances of the fraud" in order to meet this enhanced pleading standard. Anderson v. USAA Cas. Ins. Co., 221 F.R.D. 250, 253 (D.D.C. 2004) (quoting DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990)); see also In re U.S. Office Prods. Sec. Litig., 326 F. Supp. 2d 68, 73 (D.D.C. 2004) ("[T]he circumstances that the claimant must plead with particularity include matters such as the time, place, and content of the false misrepresentations, the misrepresented fact, and what the opponent retained or the claimant lost as a consequence of the alleged fraud." (citing United States ex rel. Totten v. Bombardier Corp., 286 F.3d 542, 551-52 (D.C. Cir. 2002)); see Shekoyan v. Sibley Int'l Corp., 217 F. Supp. 2d 59, 73 (D.D.C. 2002) ("Conclusory allegations that a defendant's actions were fraudulent or deceptive are not sufficient to satisfy Rule 9(b)." (citation omitted)).

Additionally, complaints brought based on Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, as amended by the Private Securities Litigation Reform Act of 1995 ("PSLRA"), must meet a higher pleading standard in order to survive a motion to dismiss than the standard that applies to a typical motion to dismiss brought under the Federal Rules. See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319-20 (2007). Specifically, the PSLRA requires plaintiffs who allege claims of material false statements to: (1) "specify each statement alleged to have been misleading [and] the reason or reasons why the statement is misleading;" and (2) "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(1)-(2) (2006).

In evaluating the sufficiency of a plaintiff's scienter allegations in Section 10(b) and Rule 10b-5 actions, the Court must consider "competing inferences rationally drawn from the facts alleged," in addition to the inferences urged by the plaintiff. Tellabs, 551 U.S. at 314. For the Court to determine that a complaint has pled facts that give rise to a "strong inference" of the defendant's requisite state of mind, the inference of scienter "must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." Id. Further, the plaintiff's allegations must not be "scrutinized in isolation" but rather considered collectively. Id. at 323. In short, the question the Court must consider in evaluating the defendants' motion to dismiss is: accepting as true the plaintiffs' allegations as a whole, "would a reasonable person deem the inference of scienter at least as strong as any opposing inference?" Id. at 326.

Moreover, when evaluating a motion to dismiss brought pursuant to Federal Rule of Civil Procedure 12(b)(6), see Defs.' Mot.; Defs.' Mem. at 12, the Court must construe the allegations and facts in the complaint in the light most favorable to the plaintiffs and must grant the plaintiffs the benefit of all inferences that can be derived from the facts alleged, Tellabs, 551 U.S. at 319; Barr v. Clinton, 370 F.3d 1196, 1199 (D.C. Cir. 2004) (citing Kowal v. MCI Commc'n Corp., 16 F.3d 1271, 1276 (D.C. Cir. 1994)). Moreover, in deciding whether to dismiss a claim under Rule 12(b)(6), the Court can only consider "the facts alleged in the complaint, any documents either attached to or incorporated in the complaint and matters of which [the Court] may take judicial notice." E.E.O.C. v. St. Francis Xavier Parochial Sch., 117 F.3d 621, 624 (D.C. Cir. 1997) (citation omitted). In addition, a complaint need not plead "detailed factual allegations," but the factual allegations included "must be enough to raise a right to relief above the speculative level" and to "nudge[]... claims ...


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