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COHEN, MILSTEIN, HAUSFELD & TOLL, P.L.L.C Steven J. Toll Daniel S. Sommers (DS-2084) Adam Savett (AS-5334) 1100 New York Avenue, N.W. West Tower, Suite 500 Washington, D.C. 2005 Telephone: [phone] Facsimile: [phone] Elizabeth A. Berney 150 East 52nd Street, 30th Floor New York, New York 10022 Telephone: [phone] Facsimile: [phone] Lead Counsel for Lead Plaintiffs
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW JERSEY
In Re DATATEC SYSTEMS, INC., SECURITIES LITIGATION This Document Relates to: All cases
) ) ) ) ) ) ) ) ) )
Master File No. 2:04-CV-525 WGB-MCA (Document Electronically Filed) CONSOLIDATED AMENDED CLASS ACTION COMPLAINT FOR VIOLATIONS OF FEDERAL SECURITIES LAWS JURY TRIAL DEMANDED
Lead Plaintiffs Yola Sherman, M. Ronald Sherman, Jean T. Beaubien, William E. Garrett, Eugene E. Epstein and Joan Shalant (the Datatec Lead Plaintiff Group or Plaintiffs), through their attorneys, bring this action on behalf of themselves and all other persons similarly situated, on personal knowledge as to themselves and their own activities, and as to all other matters, based upon the investigation of Plaintiffs counsel, which included, among other things:
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(i) interviews of former employees of Datatec Systems, Inc. (ADatatec or the Company) and other persons with knowledge and information concerning the matters alleged herein, including the confidential sources described below; (ii) review and analysis of the public filings of Datatec, including its filings with the Securities and Exchange Commission (SEC); and (iii) review and analysis of news articles, press releases, announcements, and analysts' reports by or relating to Datatec. Plaintiffs believe that further evidentiary support for the allegations set forth below will exist after a reasonable opportunity for discovery. CONFIDENTIAL SOURCES Confidential sources (also referred to as CS-__) who provided information in connection with Plaintiffs= counsel's investigation include the following: CS-1: Confidential Source 1 is a former Datatec project administrator, who worked at Datatec from approximately six years prior to the Class Period (defined below) through approximately four months after the Class Period. CS-2: Confidential Source 2 is a former high level technology executive at Datatec, who worked at the Company commencing approximately seven years prior to the Class Period through almost one year after the end of the Class Period. CS-2 had frequent regular direct dealings with the Chief Executive Officer, Chief Financial Officer, Chief Operating Officer and other top executives of the Company. CS-3: Confidential Source 3 is a former Datatec national project manager, who worked at Datatec commencing approximately four years prior to the Class Period through approximately one week after the Class Period began. Throughout the remainder of the Class Period and afterwards, CS-3 kept informed of events at
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Datatec by remaining in close personal contact and frequently conversing with employees (mostly other project managers) who remained at Datatec. CS-4: Confidential Source 4 is a former high level sales executive at Datatec, from approximately 14 years prior to the Class Period through over one year after the Class Period. CS-5: Confidential Source 5 is a former Datatec collections manager, who worked at the Company for approximately 15 years, until approximately one year prior to the Class Period. Thereafter, including throughout the Class Period, CS-5 kept in contact with, and had frequent conversations with former and then current Datatec employees. CS-5 worked closely with Datatec=s financial officers during CS-5's long tenure at Datatec. CS-6: Confidential Source 6 is a former Datatec regional operations manager, who worked at the Company commencing approximately five years prior to the Class Period through approximately 3 months after the Class Period. CS-7: Confidential Source 7 is a former Datatec product manager involved with Datatec=s eDeploy product, who worked at the Company from approximately seven years prior to the Class Period through the end of the Class Period. NATURE OF THE ACTION 1. This is a federal class action on behalf of purchasers of Datatec securities between
June 26, 2003 and December 16, 2003, inclusive, (the AClass Period@), seeking remedies under the Securities Exchange Act of 1934 (the AExchange Act@). 2. Datatec was essentially, at its core, a company which stringed the cable needed by
new stores and other facilities which required computer access. The business was neither a 3
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profitable one nor an advanced technology company which would attract investors. Competition from local cable stringing companies, which did not have Datatecs enormous overhead, was fierce. According to CS-2, the business should have failed years ago, and was only kept alive through Defendants fraudulent practices for obtaining financing from investors and its credit facilities. 3. In fact, both before and during the Class Period, Datatec could not meet its
payroll or other bills without resorting to the manipulations described herein, which included a repeatedly employed phantom invoicing scheme and a phantom products scheme designed to portray the Company as a high technology company rather than as a cable stringing company. 4. Thus, throughout the Class Period, Defendants gave the investing public a false
picture of the Company=s financial condition, balance sheet, and products, and failed to disclose that the Company had become reliant on fraudulently-obtained financing. 5. Indeed, on June 26, 2003, Defendant Isaac Gaon (Gaon), the Company=s CEO,
told investors that the Company was on track to post earnings for fiscal year 2004 (ending April 30, 2004) of $0.14 to $0.16 per share. On September 15, 2003, Defendants reiterated favorable fiscal 2004 full year earnings guidance, of $0.12 per share. 6. On December 5, 2003, Datatec surprised investors with the news that Gaon had
stepped down as Chairman and CEO of the Company, and been replaced by a new CEO, Raul Pupo. The Company also announced that board member Mark Berenblut had resigned. 7. Also on December 5, 2003, Datatec announced that it was retracting its
previously announced earnings estimates for Fiscal 2004. Far from earning $0.14 to $0.16 per share, or $0.12 per share, the Company would suffer a net loss for the fiscal quarter ended October 31, 2003, as well as an overall net loss for Fiscal 2004. Although the Company=s stock 4
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price dropped substantially on the news (nearly 34%), the full impact of the adverse news did not come out for almost another two weeks. 8. On December 17, 2003, the close of the Class Period, Datatec announced that it
would suffer a $10 million loss for the fiscal quarter ended October 31, 2003. In addition, the Company told investors it was delaying the filing with the SEC of its quarterly report for the quarter ending October 31, 2003, and that the Company=s Audit Committee had decided to hire outside counsel to conduct an independent review of the Company=s valuation of its long-term contracts. In addition, the Company advised investors that on December 12, 2003, IBM Credit had informed the Company that it would not provide Datatec with a written default waiver for the fiscal quarter ended October 31, 2203. The Company=s stock fell another 15% on extremely high volume of 2.3 million shares. JURISDICTION AND VENUE 9. This Court has jurisdiction over the subject matter of this action pursuant to 28
U.S.C. ''1331 and 1337 and Section 27 of the Exchange Act (15 U.S.C. ' 78aa). 10. The claims asserted herein arise under Sections 10(b) and 20(a) of the Exchange
Act (15 U.S.C. '' 78j(b) and 78t(a)) and Rule 10b-5 promulgated thereunder (17 C.F.R. ' 240.10b-5). 11. Venue is proper in this District pursuant to Section 27 of the Exchange Act (15
U.S.C. ' 78aa) and 28 U.S.C. ' 1391(b). Substantial acts in furtherance of the alleged fraud, including the preparation and dissemination of materially false and misleading information, and/or its effects have occurred within this District. In addition, Datatec was headquartered in Fairfield, New Jersey, within this District, at all times relevant to this litigation.
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12.
In connection with the acts and omissions alleged in this complaint, Defendants,
directly or indirectly, used the means and instrumentalities of interstate commerce, including, but not limited to, the United States mails, interstate telephone communications, and the facilities of the national securities markets. PARTIES Plaintiffs: 13. On December 23, 2004, the Court appointed Yola Sherman, M. Ronald Sherman,
Jean T. Beaubien, William E. Garrett, Eugene E. Epstein and Joan Shalant to serve as Lead Plaintiffs pursuant to 15 U.S.C. ' 78(u)-4. Lead Plaintiffs purchased Datatec common stock at artificially inflated prices during the Class Period and were damaged thereby. Certifications for the Lead Plaintiffs were previously submitted to the Court. Defendants: 14. Defendant Isaac J. Gaon (Gaon) served as Datatec=s Chairman of the Board
from December 1997 until his resignation from all his positions at Datatec on or about December 5, 2003. Gaon also served as a Director from 1992 until his December 2003 resignation; and as Datatecs Chief Executive Officer from October 1994 until his December 5, 2003 resignation. In addition, Gaon served as Datatecs CFO from April 1992 until October 1994. Gaon is also a chartered accountant. 15. Defendant Mark J. Hirschhorn (Hirschhorn) served as Datatec=s Chief Financial
Officer from approximately March 3, 2003, through the Class Period. 16. Defendants are liable as direct participants with respect to the wrongs complained
of herein. In addition, Defendants were controlling persons within the meaning of Section 20(a) of the Exchange Act. Each exercised his power and influence to cause the Company to 6
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engage in the fraudulent practices complained of herein. In addition, on July 22, 2003, Defendants each signed Section 302 certifications pursuant to Sarbanes-Oxley that, among other things, Defendants had reviewed Datatecs 2003 Form 10-K, and that the financial statements, and other financial information included therein fairly presented in all material respects Datatecs financial condition, results of operations and cash flows, and that Defendants were responsible for establishing and maintaining Datatecs disclosure controls and procedures. 17. It is appropriate to treat Defendants as a group for pleading purposes and to
presume that the materially false, misleading and incomplete information conveyed in the Companys public filings, press releases, and other public statements, are the collective action of the narrowly defined group of Defendants identified herein. During the Class Period, the Defendants, as senior executive officers and/or directors of Datatec, directly participated in the management of the Company, were directly involved in the day-to-day operations of the Company at the highest levels, and were privy to confidential and proprietary information concerning Datatec, its operations, finances, financial condition, present and future business prospects. Defendants also had access to material adverse non-public information concerning Datatec. Because of their positions with Datatec, Defendants had access to non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents, conversations and connections with other corporate officers and employees, attendance at management and board of directors meetings and committees thereof and via reports and other information provided to them in connection therewith. Because of their direct participation in the activities complained of herein, and possession of such information, Defendants knew or recklessly disregarded the fact that adverse
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facts specified herein had not been disclosed to, and were being concealed from, the investing public. 18. Defendants, because of their positions with the Company, controlled and/or
possessed the authority to control the contents of its reports, press releases and presentations to securities analysts and through them, to the investing public. Defendants were provided with copies of the Company=s reports and press releases alleged herein to be misleading, prior to or shortly after their issuance and had the ability and opportunity to prevent their issuance or cause them to be corrected. Thus, Defendants had the opportunity to commit the fraudulent acts alleged herein. 19. As senior executive officers and/or directors and as controlling persons of a
publicly-traded company whose common stock was, and is, registered with the SEC pursuant to the Exchange Act, and was traded on the NASDAQ Small Capital Market (ANASDAQ@) and governed by the federal securities laws, Defendants had a duty to disseminate promptly accurate and truthful information with respect to Datatec=s financial condition and performance, growth, operations, financial statements, business, products, markets, management, earnings and present and future business prospects, to correct any previously issued statements that had become materially misleading or untrue, so that the market price of Datatec=s common stock would be based upon truthful and accurate information. Defendants= misrepresentations and omissions during the Class Period violated these specific requirements and obligations. 20. Defendants are liable as participants in a fraudulent scheme and course of conduct
that operated as a fraud or deceit on purchasers of Datatec common stock by disseminating materially false and misleading statements and/or concealing material adverse facts. The scheme: (i) deceived the investing public regarding Datatec=s business, operations and 8
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management and the intrinsic value of Datatec common stock; (ii) enabled Datatec to obtain more than $8.4 million in private placements and other financing transactions; (iii) allowed the Company to obtain waivers of default on its existing $25 million credit line with IBM; and (iv) caused Plaintiffs and members of the Class to purchase Datatec securities at artificially inflated prices. NonParty Datatec: 21. Datatec is a corporation organized under the laws of Delaware with its principal
executive offices located at 1275 Alderman Drive, Alpharetta, Georgia 30005. On December 14, 2004, Datatec filed a bankruptcy petition pursuant to 11 U.S.C. 1101 et. seq. Accordingly, Datatec is not named as a defendant herein at this juncture due to its bankruptcy filing and the protections afforded by the automatic bankruptcy stay. THE FRAUDULENT SCHEMES 22. Defendants described Datatecs business as follows:
Datatec Systems, Inc., and its subsidiaries . . . are in the business of providing rapid and accurate technology services and licensing software tools designed to accelerate the delivery and management of complex Information Technology (IT) solutions for technology providers, primarily Original Equipment Manufacturers (OEMs), systems integrators, independent software vendors, telecommunications carriers and service providers . . . as well as to a select number of Fortune 2000 customers in the United States and Canada. (Datatec Form 10-K for the fiscal year ending 4/30/03, filed 7/23/03) 23. However, according to CS-2, Datatec was essentially, at its core, a company
which stringed the cable needed by new stores and other facilities which require computer access. Datatecs core business was not profitable, and faced fierce competition from local cable stringing companies, which did not have Datatecs enormous overhead. Datatec could not meet its payroll, vendor and other bills without fraudulent manipulation.
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24.
Thus, throughout the Class Period, Defendants tried to portray Datatec as an
advanced technology company, which was creating new breakthrough software products which would appeal to investors. Defendants gave the market place a false picture of the Company=s financial condition, balance sheet, and products, and failed to disclose that the Company had become reliant on financing obtained with phantom invoices, and that the Defendants were touting essentially non-existent products to keep investors pouring money into the Company when Datatec was neither profitable nor solvent. The Phantom Invoicing Scheme: 25. Throughout the Class Period, Defendants failed to disclose that the Company was
buttressing its financials with phantom invoices, and had become reliant on financing obtained through this same fraudulent mechanism. Several confidential sources, including CS-1, CS-2, CS-3 and CS-5, described the following phantom invoicing scheme, which Defendants personally directed: 26. Both prior to the Class Period and during the Class Period with increasing
frequency and magnitude, Defendants regularly placed phantom invoices on Datatecs books, to overstate the Companys revenues, and to enable Datatec to obtain critical accounts receivable financing through its $25 million credit facility with IBM Credit LLC (AIBM Credit@). Datatec=s true but undisclosed financial condition was so precarious that Datatec needed the fraudulentlyobtained accounts receivable financing for Datatec to meet its semi-monthly payroll, and to avoid having Datatec=s vendors cut off essential supplies. 27. Specifically, according to CS-1, CS-2, and CS-5, Defendants, including Gaon,
directed Datatec=s employees to post to Datatec=s accounts receivable phony invoices for work that was not yet done and/or not yet billable. According to CS-2, this same phantom invoicing 10
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device was used to cure a variety of Datatecs business problems. First, at the end of each quarter, Defendants directed phantom invoices to be issued so that the Company would recognize more income on its public (SEC) financial filings. Second, prior to each semi-monthly payroll, the head of Datatecs HR department would tell Defendants, including Gaon, that there was not enough money to meet the payroll and Defendants would cure the problem by ordering phantom invoices to be issued and posted to the Companys accounts receivable, thereby obtaining approximately 85% financing on those receivables. Third, Datatec also frequently received threats from its supply vendors to cut off the Companys essential supplies if overdue payments were not forthcoming. Again, the solution was to issue phantom invoices and thereby fraudulently obtain accounts receivable financing. 28. Defendants constantly faced the prospect of not being able to meet payroll
throughout the Class Period. Datatec was also constantly in jeopardy of being cut off by its vendors, such as Graybar (which sells just about everything that Datatec would use at a job site such as oil, screws, brackets, and clamps), Hertz (which rented Datatec the vans and lifts used at all of Datatecs job sites), materials companies, and cable companies. According to CS-2, Gaon attended the vendor meetings held at Datatec which concerned getting money to the vendors who were threatening to discontinue sending needed supplies to Datatec. 29. On each of the above-described occasions, Defendants, usually Gaon himself,
telephoned certain Company managers, and ordered them to direct the Companys project administrators to post phantom invoices to the Companys accounts receivable. These invoices listed work which the Company expected to do in the coming weeks as already complete. CS2 often personally overheard Defendant Gaon issuing such instructions to Datatecs managers during the Class Period. The managers then called in the project administrators who reported to 11
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them, and gave them the same instructions. CS-1s manager called in CS-1 for a meeting shortly before every payroll, and instructed CS-1 to post the phantom invoices, while commenting: Corporate says we need to do it again. 30. Datatecs project administrators complained about these instructions. CS-3, a
national project manager, reported that at least half of the 8 project administrators with whom he had contact complained about being asked to post phantom invoices. Some project administrators objected strenuously. According to CS-1, one project administrator, who worked in the Companys Dallas office, and who had an accounting degree, complained to supervisory personnel that what Defendants were asking them to do was illegal, and that the Company could not post phantom invoices. Defendants responded by moving this project administrator into an area with different responsibilities (collections). 31. Upon receipt of the instructions handed down from their managers, the project
administrators thereupon obtained information from project managers as to future estimated work to be done by the Company, and pre-invoiced the work on the Companys accounts receivable, as if the work had already been done. Once the pre-invoice was placed on the Companys accounts receivable, the Company would receive financing from IBM Credit of approximately 85% of the amount of the invoice. 32. In the ensuing weeks, if and when the pre-invoiced work was performed, the
Company reversed the pre-invoice and issued a real invoice to the customer. These manipulations played havoc with the Companys billing processes, and wasted enormous amounts of Datatec employees time. CS-1 described the havoc created by the pre-invoicing as a nightmare, and said that it resulted in triple the amount of work. As a result of the extensive pre-invoicing, the Companys accounts receivable bore no relation to reality, and billing had to 12
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be done by hand to try to avoid sending the phantom pre-invoices to customers who were not supposed to receive bills for work that was not yet performed. According to CS-3, who was a national project manager, Datatecs project managers were constantly concerned that preinvoices would accidentally be sent to their customers for work that was not yet performed. CS3 heard of a number of occasions prior to and during the Class Period when pre-invoices were in fact sent to customers erroneously. For instance, according to CS-3, in approximately mid-2003, AT&T / Banc One received one of these funny invoices for an obnoxious number approximately $75,000 or $125,000. Datatec sales representatives or project managers then had to back track and give excuses to their irate customers for such bills, such as It was just a clerical error. 33. The phantom invoicing began well before the Class Period on a limited basis, and
continued to snowball, until it became a regular occurrence throughout the Class Period. For instance, in 1999, the project manager on a project for LibbyOwensFord complained to CS-3 about having to invoice ahead of time, but the invoicing was only a little ahead of time, about a week. CS-1, CS-2, CS-3 and CS-5 noted that the pre-invoicing increased throughout the years, and during the Class Period, was the regular way of doing business. 34. The impact on accounts receivable from the pre-invoicing was dramatic, and
became more so over time. CS-5 reported that in 2002, only $1 million out of $11 million on the accounts receivable aging was real. Nonetheless, despite the fact that Defendant Gaon had instructed Datatecs employees to engage in pre-invoicing, according to CS-5, Gaon sometimes played dumb as to the impact on the accounts receivable aging. CS-5 reported attending meetings in approximately 2002, with Gaon, as well as the then-CFO, and another manager, during which the following conversation repeatedly took place: 13
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Gaon: I dont understand why you cant collect more money on the accounts receivable. CS-5: Because the invoices arent real and havent been sent to the customers yet. Gaon: Who told people to invoice when the invoices arent real? CS-5: You did. 35. Although CS-5 witnessed the conversation recounted in the preceding paragraph
prior to the Class Period, the situation kept escalating and was even worse during the Class Period. CS-2 reported that during the Class Period, pre-invoicing was a frequent occurrence, the regular way of doing business. CS-2 reported that the amounts directed to be pre-billed were substantial and meaningful, usually over $100,000, and frequently involved Datatecs largest accounts, including Home Depot. CS-2 often heard Defendant Gaon say during the Class Period, We need to pre-bill $100,000 of the project today. CS-2 opposed the pre-billing strategy in conversations with Gaon. However, CS-2 reported that at no time during his seven years at Datatec (which included the Class Period) did Gaon abandon the pre-billing practices. 36. Similarly, CS-3 reported that the pre-invoicing continued to escalate: There were
progressive stages: When Datatec was doing better, there was just a little pushing ahead on invoices, with the excuse from management that it was just so that the Company could close out the month. Later, the invoicing was required to be more and more ahead of time. For instance, CS-3 reported that the invoicing for a large project involving AT&T and Banc One was well ahead of time. Project managers started receiving emails every two weeks, just before payroll, to get everything in that could conceivably lead to billings. By 2003, and during the Class Period, if there was any remote possibility of invoicing an item, Defendants pre-invoiced it.
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37.
Not surprisingly given what the finance personnel were asked to do, there was
enormous turnover in Datatecs finance department throughout the years. CS-5 reported that there were eight different bosses (usually the controller) in the finance department over the course of 5 years. According to CS-1, there was a whole shuffle in the finance department beginning in 2003, in which a whole new crew was brought in by Defendant Gaon. The previous payroll person was the only individual who stayed with the Company. About 8 out of 10 people in the finance department were swapped in 2003. 38. According to CS-5, Defendants also furthered their pre-invoicing scheme by
manipulating audits of Datatecs accounts receivable. When auditors sent letters to customers requesting confirmation of the phantom accounts receivable listed on Datatecs books, Defendants arranged to have Datatecs sales representatives and project managers prevail upon Datatecs customers to either discard the auditor letters or falsely confirm the phantom invoices, as a favor. Smaller customers generally went along with confirming to the auditors that invoices were true when they were not. Datatecs major customers (such as Dayton Hudson, Walgreens and Wal-Mart) would not confirm to the auditors that the invoices were true, but instead often discarded the auditor letters without responding to them. 39. CS-5 reported that Datatec had other finance companies prior to IBM Credit, and
that whenever Datatec got in trouble with its financing company (i.e., the finance company finally did an extensive audit and learned what was really occurring, or became completely dissatisfied because the poor collections did not reflect the amounts shown on the accounts receivable), Datatec switched financing companies. Prior to IBM Credit, there was a finance company called Finova which Datatec had these types of problems with.
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40.
According to CS-1 and CS-5, towards the end of the Class Period, auditors for
IBM Credit went on a rampage and undertook a very extensive audit of Datatec=s accounts receivable because the accounts receivable and the amounts actually paid to Datatec by customers against the accounts receivable -- were so askew that they did not make any sense. IBM Credit demanded extensive back-up materials from Defendants, and apparently finally learned the truth about the phony invoicing 41. A few days before the end of the Class Period, IBM Credit essentially cancelled
Datatecs credit facility. Previously, commencing with the fiscal quarter ended January 31, 2001, through and including the fiscal quarter ended July 31, 2003, IBM Credit had always provided the Company with written default waivers for the Companys non-compliance with certain financial covenants in the IBM Credit facility. However on December 12, 2003, IBM Credit informed the Company that it would not provide the Company with a written waiver for the fiscal quarter ended October 31, 2003. 42. The investing public and others were kept in the dark about Defendants
fraudulent invoices, the full extent of Datatecs non-compliance with IBM Credit=s financing requirements, and the true state of Datatecs financial condition indicated by Defendants phantom invoicing scheme. The Phantom Products Scheme: 43. In addition, during the Class Period, Defendants touted certain new software
products, including an Asset Guardian service, as well along in development, in order to entice investors to invest in the Company. The following information regarding Defendants phantom products was related by CS-2, a high-level former technology executive at Datatec:
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44.
Asset Guardian was, by definition a product which couldnt exist -- particularly
as Defendants conceived and touted it, according to CS-2. The product was supposed to manage the entire life cycle of a technology asset (such as a computer, phone device, or any other technology device) from its earliest conception to the final phases of disposal. The product was supposed to manage technology assets life cycles all the way from procurement (sourcing, purchasing), through deployment, configuration, installation, help desks, maintenance, depreciation, technology refresh, planned obsolescence, retirement and disposal, and everywhere in-between. The project was impossibly over-ambitious. A lot of large companies far larger than Datatec aspire just to bite off just a small piece of the life cycle management products, and make a living from that, according to CS-2. 45. In reality, Defendants knew or recklessly disregarded that Asset Guardian was
utter pie in the sky, and was impossible to produce with the limited financial and manpower resources Defendants allotted to it. However, Defendant Gaon knew that investors would like the concept. According to CS-2, Defendants thus merely went through the motions of trying to develop the Asset Guardian product, and tried to put together a skeletal product, like a slide show, to show to investors. 46. Some of the specific facts which Defendants knew or disregarded as to the
impossibility of Datatec developing Asset Guardian, given Datatecs limited resources, included the following: (a) According to CS-2 (who made his views known to Defendants), development of the extraordinarily ambitious Asset Guardian project would have required millions upon millions of dollars (perhaps $30 million, but it is difficult to know, since its never been done and nothing like that exists) and a coordinated effort of hundreds of top programmers at a powerhouse software development company such as 17
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IBM or Microsoft. A company of Datatecs size couldnt pull it off if it had 100 years, according to CS-2. (b) Defendants development efforts were paltry for show efforts amounted to only the tiniest fraction of what the project required. Defendants merely allocated to the project approximately $250,000 (for software and database applications and hardware), and approximately twelve programmers all together, consisting of some offshore developers, and the Datatec team which had previously failed to produce other viable software products whom CS-2 referred to as the failed eDeploy team. CS-7, a former project manager for eDeploy, explained that, after a series of layoffs, Datatecs software development division consisted of only 10 people by May 2001, and continued to be cut until the few remaining people were all laid off at the end of 2003. Datatecs competency was never in software development; it was not a software development company. The same small team of programmers went from one failed project to another, while Defendants touted the failed projects. Asset Guardian was merely the last of Datatecs phantom products. These
(c)
47.
products only existed as power point presentations. Defendants would put on dog and pony shows for investors, and act as if significant development of the product was only days away. Investors would throw money at the Company, which Defendants would promptly squander. 48. Another failed Datatec product was eDeploy. Datatec previously received $10
million of financing from IBM for eDeploy. Defendants went through the $10 million in approximately a year and a half. At the same time, Datatec had lavish offices in Denver, with budgets for ski vacations for employees, a frozen margarita machine and foosball in the office: It was a dot.com party, according to CS-2. 49. eDeploy was supposed to manage a technology deployment project when devices
were located in many different locations. However, it wound up being a web-based spreadsheet instead of a product with any intrinsic value. eDeploy was a skeleton, extremely bare bones compared to what it was supposed to be. It was more work to use eDeploy than not to, and it 18
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created more work (administration and paperwork) than it saved, because it was so poorly designed and executed. Defendants made rules attempting to force Datatecs managers to use eDeploy in their work, but the managers refused to use eDeploy because it created so much extra work. Some Datatec managers were fired for refusing to use eDeploy. Outside companies who licensed eDeploy from Datatec discovered that it was unusable in its natural state. These companies either discontinued using eDeploy, or revised it themselves. CS-2 summed up eDeploy as follows: It was just another failed software product. 50. Another such failed Datatec product, which the same programmers worked on,
was IWPS. IWPS was supposed to be a software configuration tool, which configured computer devices wholesale loading software onto hundreds of computers in an unattended and automatic fashion, to the customers specs, without the need for anyone to spend one on one time with the individual computers. It never worked. 51. The same developers who failed at putting together IWPS and eDeploy went on to
fail with Asset Guardian. Asset Guardian never saw the light of day, and was never licensed or used. 52. Behind each of Datatecs phantom products, there was someone usually a crony
of Defendant Gaons who had the vision for the product. 53. According to CS-2, Michael Lazar was the individual responsible for the vision
for Asset Guardian. Lazar and Gaon went way back and had previously worked with one another at Glassgal. Raul Pupo, Datatecs new CEO after Gaon resigned, immediately recognized that Asset Guardian was valueless. During Pupos first two weeks as CEO, he dismissed Lazar and everyone else who had anything to do with Asset Guardian. MATERIALLY FALSE AND MISLEADING 19
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STATEMENTS ISSUED DURING THE CLASS PERIOD 54. The Class Period began on June 26, 2003. On that date, the Defendants issued a
press release announcing the financial results of its fourth quarter of fiscal 2003 (ending April 30, 2003) and revenue and earnings guidance for fiscal 2004.1 Defendants reported that for fiscal 2003, the Company would report $125.1 million in revenues and $1.4 million in income, or $0.04 per share. 55. Also on June 26, 2003, with respect to fiscal 2004 (ending April 30, 2004),
Defendants stated the following: For fiscal 2004, Datatec expects that sales, excluding potential sales from new government opportunities, will be in the range of $120 to $125 million and earnings per share will be between $0.14 and $0.16. The Company expects to be profitable in all four quarters. Any Government sales in the year would be incremental to both the top and bottom line forecasts. 56. Chairman and CEO Gaon stated that the Company would be working to improve
its gross profit margins, profitability and cash flow, in an attempt to reduce the Company=s future working capital needs: The Company expects to achieve improvements to gross margins, profitability and cash flows by taking a more selective approach to project opportunities, adjusting its sales mix and continuing to focus on expense control. Gaon told the public that the Company=s recent acquisition of Millennium Care, combined with Datatec=s Asset Guardian software-enabled services, was expected to contribute to the gross margin improvement. 57. The statements in the preceding three paragraphs were materially false and
misleading when made for the following reasons:
The Company=s fiscal year begins on May 1, and thus its quarters break down as follows: Q1 (May 1 to July 31); Q2 (August 1 to October 31); Q3 (November 1 to January 31); Q4 (February 1 to April 30).
1
20
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(a)
The statements setting forth Datatecs financial results for its fourth quarter of fiscal 2003 (ending April 30, 2004) were materially false and misleading because they (i) failed to disclose that the results were based on extensive pre-invoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting its semimonthly payroll and its bills from Datatecs vendors with fraudulentlyobtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills. The statements setting forth Datatecs positive revenue and earnings guidance for fiscal 2004 lacked any reasonable basis and were materially false and misleading because they (i) failed to disclose that the guidance was based on continuing and increasing Defendants improper practice of extensive pre-invoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting and could only continue to meet its semi-monthly payroll and its bills from Datatecs vendors with fraudulently-obtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills, and knew, or recklessly disregarded that the revenue and earnings guidance had no basis in reality. The statement that Datatecs Asset Guardian software-enabled services is expected to contribute to . . . gross margin improvement had no reasonable basis and was materially false and misleading because the Asset Guardian software was essentially pie in the sky and could not contribute to . . . gross margin improvement. Defendants knew, or recklessly disregarded, that the Asset Guardian software did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. On July 3, 2003, Datatec announced that it had received aggregate gross
(b)
(c)
58.
proceeds of $4.9 million from six funds managed by The Palladin Group L.P., one of the Companys current lenders, through the issuance of Subordinated Secured Convertible Notes.
21
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The Company also issued four-year warrants to purchase an aggregate of 875,000 shares of Common Stock at an exercise price of $1.32 per share to the purchasers of the Notes. 59. On July 23, 2003, the Company filed its annual report on Form 10-K for its fiscal
2003 year ended April 30, 2003 (the 2003 Form 10-K). The 2003 Form 10-K was signed and certified by defendants Gaon and Hirschhorn. The Management Discussion and Analysis (MD&A) section of the 2003 Form 10-K contained the following statements regarding the Companys critical revenue recognition policies: Critical Accounting Policies and Use of Estimates Revenue Recognition ... Services from deployment activities are performed primarily under long-term contracts, but may be performed under short-term workorders or time and material arrangements. The Company's typical long-term contract contains multiple elements designed to track the various services required under the arrangement with the customer. These elements are used to identify components of progress billings, but are combined for revenue recognition purposes. The Company recognizes revenue earned under long-term contracts utilizing the percentage of completion method of accounting by measuring a contract's percentage of completion as determined by the percentage of total costs incurred to date to total estimated costs. Contracts are reviewed at least quarterly and if necessary, revenue, costs and gross margin are adjusted prospectively for revisions in estimated total contract value and total estimated contract costs. Estimated losses are recognized when identified. Payment milestones differ according to the customer and the type of work performed. Generally, the Company invoices customers and payments are received throughout the deployment process and, in certain cases, in advance of work performed if a substantial amount of up front costs are required. In certain cases payments are received from customers after the completion of site installation. However, revenue and costs are only recognized on longterm contracts to the extent of the contracts percentage of completion. Costs and estimated earnings in excess of billings, which is classified as a current asset, is recorded for the amount of revenue earned in excess of billings to customers. 22
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Deferred revenue is recorded as a current liability for the amount of billings in excess of revenue earned. The Company records payments received in advance and services to be supplied in the future under contractual agreements as billings in excess of costs and estimated earnings until such related services are supplied. [Emphasis supplied.] 60. The statements in the preceding paragraph were materially false and misleading
when made for the following reasons: (a) The statement that revenue and costs are only recognized on long-term contracts to the extent of the contracts percentage of completion was false and misleading because Defendants were causing Datatec to recognize substantial revenues well prior to the performance of the work on Datatecs long-term contracts, pursuant to Defendants undisclosed phantom invoicing scheme. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing of work on long-term contracts long before completion, in order to bolster revenues. In addition, Defendants were directly involved with invoicing work on long term contracts prior to completion to obtain fraudulent accounts receivable financing in order to meet payroll and vendor bills, and knew, or recklessly disregarded that Datatecs stated revenue recognition policy was continually being violated. The statement that Generally, the Company invoices customers and payments are received throughout the deployment process and, in certain cases, in advance of work performed if a substantial amount of up front costs are required failed to disclose that Defendants in fact were causing Datatec to place phantom pre-invoices on its accounts receivable prior to the deployment process, or the appropriate stage in the deployment process, and well in advance of work being performed regardless of the up front costs required. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing of work prior to deployment, to bolster revenues, and to obtain fraudulent accounts receivable financing in order to meet payroll and vendor bills. The MD&A in the 2003 Form 10-K also contained a chart purporting to
(b)
61.
summarize Datatecs defaults in its financial covenants (e.g., net profit to revenue and annual revenue to working capital ratios) with IBM Credit during each fiscal quarter, beginning in the fiscal quarter ended as of January 31, 2001, which IBM Credit had waived. For instance, the 23
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chart listed the following financial covenants with which Datatec had failed to comply for quarters ending in 2003: Period Jan. 31, 2003 Jan. 31, 2003 Apr. 30, 2003 Apr. 30, 2003 Covenant Annual revenue to working capital Debt service ratio Debt service ratio Net profit to revenue Requirement Greater than 5.0 to 1.0 and equal to or less than 25.0 to 1.0 Equal to or greater than 2.0 to 1.0 Equal to or greater than 1.25 to 1.0 Equal to or greater than 0.10 percent Actual (126.9) to 1 0.2 to 1 (1.73) to 1 (3.38%)
The introductory material to the chart in the 2003 Form 10-K explained that: The Company and IBM Credit entered into an Acknowledgement, Waiver and Amendment to the Inventory and Working Capital Financing Agreement as of the end of each quarter since January 31, 2001 by which IBM Credit has waived the Companys defaults. 62. The statements in the introductory material and chart referenced in the preceding
paragraph were materially false and misleading when made for the following reasons: (a) The default ratios for items involving revenues (such as annual revenue to working capital and net profit to revenue) summarized in said chart were more serious than stated, because Defendants had caused Datatec had recognized substantial revenues well prior to work being performed, pursuant to Defendants undisclosed phantom invoicing scheme. The statement that IBM had waived the Companys defaults with its financial covenants failed to disclose that Defendants had caused Datatec to engage in a pervasive fraudulent invoicing scheme, which, if known to IBM, would in all likelihood result in IBMs refusal to continue waiving Datatecs defaults with its financial covenants, and result in the termination of the accounts receivable financing upon which the Company was dependent for meeting payroll and vendor bills. The 2003 Form 10-K also contained the following description of Datatecs
(b)
63.
deployment services: 24
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The Company utilizes internally developed Web-enabled implementation tools that differentiate its deployment services. These tools, together with its proprietary processes, allow the Company to rapidly and efficiently deliver high quality and cost effective large-scale technology deployment solutions to its clients, which it does primarily on a fixed time/fixed cost basis. The components of the Company's implementation model are made up of a combination of people, processes and technology that include: The utilization of eDeploy, a Web-based software tool that provides collaboration capabilities for remote planning and design, communication capabilities through fax, voice, data, or digital photographs and monitoring capabilities, ensures that best practices are employed and that mission critical milestones or timelines are escalated to supervisory levels if missed by the responsible parties. These features and others are designed to enhance the speed, accuracy and productivity of the deployment process.
64.
The statements in the preceding paragraph were materially false and misleading
when made for the following reasons: (a) The statements that that The Company utilizes internally developed Webenabled implementation tools that differentiate its deployment services and that These tools, together with its proprietary processes, allow the Company to rapidly and efficiently deliver high quality and cost effective large-scale technology deployment solutions to its clients were false and misleading because, instead of favorably differentiating Datatecs deployment services, Datatecs internally developed Web-enabled implementation tools (such as eDeploy, the first tool listed in the 2003 Form 10-K) were rudimentary, hindered Datatecs services, and were generally not used by Datatecs personnel, who refused to utilize these tools due to their inefficiency. The statements regarding eDeploys capabilities and the statement that These features and others are designed to enhance the speed, accuracy and productivity of the deployment process were false and misleading because eDeploy was essentially a poorly-designed web-based spread sheet, which Datatecs own personnel refused to utilize because it was more cumbersome than traditional methods. In a press release dated July 23, 2003, issued in connection with the filing of the
(b)
65.
fiscal 2003 Form 10-K, Datatec stated that it had reported $125.1 million in sales for fiscal 2003, 25
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a 66% increase compared to fiscal 2002. Reported operating income for fiscal 2003 was $5.1 million compared to an operating loss of $245,000 for the prior year. Reported net income was $1.4 million or $0.04 per share in fiscal 2003 compared to a net loss of $2.7 million or $0.08 per share in fiscal 2002. 66. In the July 23, 2003 press release, Datatec reiterated fiscal 2004 revenue
guidance of $120 to $125 million and EPS guidance of $0.14 to $0.16, based upon 41 million shares outstanding. Gaon again told the public: Our primary objectives for fiscal 2004 are to improve gross margins by being more selective with respect to the projects we undertake and to increase the focus on our suite of Asset Lifecycle Software products now integrated under the Asset Guardian brand name. In the short time we have been marketing the capabilities of Asset Guardian, which incorporates IW2000, eDeploy and I-Care and their attendant services, we are very encouraged with the response and traction this offering is having with both existing clients and prospects alike. The Asset Guardian web enabled solution has a high gross margin potential and should grow at significantly higher rate than other parts of the business. 67. In the press release Gaon went on to say: Datatec is continuing to penetrate into new major OEM organizations with the expectation of securing their deployment services and we are also working diligently to increase our exposure to government opportunities through existing relationships. The Company expects to close its first government opportunity with Q2. At this time, we appear to be on track with the fiscal 2004 forecast that was announced on June 26. [Emphasis supplied.] 68. The statements in the preceding three paragraphs were materially false and
misleading when made for the following reasons: (a) The statements setting forth Datatecs financial results for fiscal 2003 were materially false and misleading because they (i) failed to disclose that the results were based on extensive pre-invoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting its semi-monthly payroll and its bills from 26
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Datatecs vendors with fraudulently-obtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills. (b) The statements reiterating Datatecs positive revenue and earnings guidance for fiscal 2004 and claiming that At this time, we appear to be on track with the fiscal 2004 forecast that was announced on June 26 lacked any reasonable basis and were materially false and misleading because they (i) failed to disclose that the guidance was based on continuing and increasing Defendants improper practice of extensive preinvoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting and could only continue to meet its semi-monthly payroll and its bills from Datatecs vendors with fraudulently-obtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills, and knew, or recklessly disregarded that the revenue and earnings guidance had no basis in reality. The statements that In the short time we have been marketing the capabilities of Asset Guardian, which incorporates IW2000, eDeploy and I-Care and their attendant services, we are very encouraged with the response and traction this offering is having with both existing clients and prospects alike and that The Asset Guardian web enabled solution has a high gross margin potential and should grow at significantly higher rate than other parts of the business had no reasonable basis and were materially false and misleading because the Asset Guardian software was essentially pie in the sky and did not have high gross margin potential. Defendants knew, or recklessly disregarded, that the Asset Guardian software did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. Five days later, on July 28, 2003, Datatec announced that it had sold 3,696,621
(c)
69.
shares of newly issued common stock to institutional and other accredited investors for gross proceeds of $3.49 million. Investors will also receive five-year warrants to purchase 1,848,306 shares of common stock at a strike price of $1.3637 per share. 27
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70.
On July 29, 2003, Datatec filed an amendment to a Form S-1 Registration
Statement (File No. 333-105654) for the sale of 8,226,247 shares of stock by certain selling shareholders. Four million shares pertained to a private placement of Datatec common stock in April 2003, through which Datatec had raised $5 million; two million shares pertained to conversion of warrants sold in connection with the same private placement; 480,000 shares pertained to conversion of warrants issued to a financial adviser in connection with the April 2003, private placement, and over 1.5 million shares were in connection with Datatecs acquisition of Millennium Care, Inc. 71. On July 31, 2003, Datatec filed a Form S-1 Registration Statement (File No.
333-107502) for the sale of another 9,546,250 shares of stock held by certain selling shareholders. The shares were previously issued to the selling shareholders upon conversion of $4.9 million aggregate principal amount of subordinate secured convertible notes issued in a private placement in July 2003. 72. On August 13, 2003, Defendants announced that Datatec was awarded a $5.8
million wireless deployment project. Defendants told the public that Datatec would receive $5.8 million to deploy wireless technologies at 170 retail locations nationwide and that [w]ork is scheduled to start immediately and will be completed by October 31, 2003, coinciding with the end of Datatec=s fiscal 2004 second quarter. However, Defendants did not reveal the identity of the purported customer who had awarded the alleged contract. 73. On September 9, 2003, Defendants issued a press release stating that it had been
awarded a contract valued at $11.6 million to deploy new LAN-based security technologies at more than 500 retail locations across North America. According to the press release, the project would start up immediately and is scheduled for completion by January 31, 2004, 28
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coinciding with the end of Datatec=s fiscal 2004 third quarter. The press release also claimed that the Companys Millennium Care division will play a pivotal role during both the planning and implementation phases . . . . Defendants again did not name the customer who purportedly contracted for these services. 74. On September 12, 2003, the Company filed a Registration Statement on Form S-1
(File No. 333-108737) for the sale of another 8,071,611 shares of stock by certain selling shareholders in the secondary market, including 5.5 million shares issued in a July 28, 2003 private placement through which Datatec received $3.49 million in proceeds. Thus, by September 12, 2003, the Company had registered a total of nearly 26 million shares for sale in the secondary market, or more than half of the Company=s issued shares. These secondary stock offerings were being made on behalf of several companies that had provided financing for the Company in exchange for common stock, such as The Palladin Group, and others. 75. On September 15, 2003, Defendants issued a press release reporting Datatecs
results for the first quarter of fiscal 2004 ended July 31, 2003, and reiterated fiscal 2004 revenue guidance of $120 to $125 million and EPS guidance of $0.12 cents based upon 50 million shares outstanding. 76. Defendants reported in this press release that Datatecs operating profits for the
first fiscal quarter of 2004 were $613,000 compared to a loss of $89,000 in the prior quarter. The net loss for the quarter was $175,000 or $0.00 per share, compared to a net loss of $1,133,000 or $0.03 per share in the prior quarter. 77. Defendant Gaon also stated in the September 15, 2003 press release that: Despite
having achieved a break-even quarter compared to a loss in Q4 in what is a continuing difficult
29
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economic environment, he was still reiterating the same guidance of 12 cents per share that we gave three months ago. 78. The September 15, 2003 press release expounded on fiscal 2004: Mr. Gaon continued, >Some 12 months ago we stated that our primary objectives were to return to profitability and to strengthen the balance sheet following the debilitating effect of the technology slow down. We fully expect to sustain the profitability that we attained in fiscal 2003, and today, our balance sheet is stronger than ever. We are committed to improving the balance sheet even further without recourse to the capital markets through a combination of operational and marketing initiatives that should start positively impacting operations from Q3 onwards. These include anticipated Government revenues to provide greater critical mass and economies of scale, the full launch of Asset Guardian software and its attendant services that we expect will generate $7m in revenues this year climbing to $15m-$18m next year at a combined gross margin of around 50%, and finally, the automation and centralization of certain internal processes and functions to reduce costs.= [Emphasis supplied.] 79. The statements in the preceding four paragraphs were materially false and
misleading when made for the following reasons: (a) The statements setting forth Datatecs financial results for first quarter of fiscal 2004 and claiming that today, our balance sheet is stronger than ever were materially false and misleading because they (i) failed to disclose that the results were based on extensive pre-invoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting its semi-monthly payroll and its bills from Datatecs vendors with fraudulently-obtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills. The statements again reiterating Datatecs positive revenue and earnings guidance for fiscal 2004, and Gaons insistence that he was reiterating the same guidance of 12 cents per share that we gave three months ago lacked any reasonable basis and were materially false and misleading because they (i) failed to disclose that the guidance was based on continuing and increasing Defendants improper practice of extensive pre-invoicing and 30
(b)
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improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting and could only continue to meet its semimonthly payroll and its bills from Datatecs vendors with fraudulentlyobtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills, and knew, or recklessly disregarded that the revenue and earnings guidance had no basis in reality. (c) The statements that operational and marketing initiatives . . . should start positively impacting operations from Q3 onwards and that these initiatives included the full launch of Asset Guardian software and its attendant services that we expect will generate $7m in revenues this year climbing to $15m-$18m next year at a combined gross margin of around 50% had no reasonable basis and were materially false and misleading because the Asset Guardian software was essentially pie in the sky and would not have a full launch anytime in the foreseeable future. Nor could Asset Guardian generate the revenues which Defendants claim they expected, nor could it achieve a combined gross margin of 50%. Defendants knew, or recklessly disregarded, that the Asset Guardian software did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. On September 15, 2003, Defendants filed Datatecs Form 10-Q for the quarterly
80.
period ended July 30, 2003. The Form 10-Q was signed by defendants Gaon and Hirschhorn. 81. The Form 10-Q described Datatecs purported revenue recognition policies as
follows (similarly to the description of these policies in the 2003 Companys 10-K): Critical Accounting Policies: Revenue Recognition The Company generates revenue from: (1) providing technology deployment services, including configuring Internetworking and computing devices to meet the specific needs of its customers, integrating these devices as well as operational and application software with a customer's existing hardware and software, and physically installing the 31
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technology on the customer's network and (2) from licensing its software to third parties. Services from deployment activities are performed primarily under longterm contracts, but may be performed under short-term workorders or time and material arrangements. The Company's typical long-term contract contains multiple elements designed to track the various services required under the arrangement with the customer. These elements are used to identify components of progress billings, but are combined for revenue recognition purposes. The Company recognizes revenue earned under long-term contracts utilizing the percentage of completion method of accounting by measuring total costs incurred to total estimated costs. Under the percentage of completion method of accounting, revenue, costs and gross margin are recognized as work is performed based on the relationship between total costs incurred and total estimated costs. Contracts are reviewed at least quarterly and, if necessary, revenue, costs and gross margin are adjusted prospectively for revisions in estimated total contract value and total estimated contract costs. Estimated losses are recognized when identified. Payment milestones differ according to the customer and the type of work performed. Generally, the Company invoices customers and payments are received throughout the deployment process and, in certain cases, in advance of work performed if a substantial amount of up front costs is required. In certain cases payments are received from customers after the completion of site installation. However, revenue and costs are only recognized on long-term contracts to the extent of the contracts' percentage of completion. Costs and estimated earnings in excess of billings, which is classified as a current asset, is recorded for the amount of revenue earned in excess of billings to customers. Accrued costs or deferred revenue is recorded as a current liability for the amount of billings in excess of revenue earned. Revenue earned under short-term workorders and time and material arrangements is recognized as the work is completed. Billings under these arrangements are typically done when the work is completed. [Emphasis supplied.] 82. The statements concerning revenue recognition in the Form 10-Q set forth in the
preceding paragraph were false and misleading for the reasons set forth in 60, and for the additional reason that the statement that revenue earned under short-term workorders and time 32
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and material arrangements is recognized as the work is completed was false and misleading because Defendants caused Datatec to recognize revenues prior to completion of short-term workorders and time and material arrangements. 83. The same Form 10-Q also set forth the partial information regarding Datatecs
liquidity difficulties: Liquidity The net loss of $19.4 million for the fiscal year ended April 30, 2001 and the net loss of $2.7 million for the fiscal year ended April 30, 2002 resulted in a strain on the Company's cash resources. Although the Company realized net income of $1.4 million for fiscal year ended April 30, 2003 and took dramatic measures to cut costs and to manage cash, it is still experiencing a significant strain on cash resources. The primary reason for the strain on resources is the increased requirements for expenditures for field personnel, job expenses and materials related to the increased revenue. As a result, the working capital financing line regularly remains at or close to its maximum allowable levels and the average days outstanding on trade payables have extended beyond normal credit terms granted by vendors. Achievement of the Company's fiscal 2004 operating plan, including maintaining adequate capital resources, depends upon the timing of work performed by us on existing projects, our ability to gain and perform work on new projects, our ability to maintain positive relations with our key vendors and our ability raise to permanent capital and replace our current working capital financing line within the timeframe required to meet our spending requirements. Multiple project cancellations, job performance related losses, delays in the timing of work performed by us on existing projects, our inability to gain and perform work on new projects, or our inability to raise permanent capital and replace our current working capital financing line in a timely fashion could have an adverse impact on our liquidity and on our ability to execute our operating plan. The Company has taken a variety of actions to ensure our continuation as a going concern. A summary of recent events and our completed or planned actions are as follows: The Company initiated and completed substantial cost saving measures during the fiscal years ended April 30, 2001 and 2002 and now believes it has a cost structure in line with our expected revenue. 33
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As a result of the increase in demand for our services and the cost reduction measures initiated over the past two years, we achieved profitability during the fourth quarter of fiscal 2002 and during fiscal 2003. We expect to be profitable throughout fiscal 2004. In April 2003, the Company raised aggregate gross proceeds of $5.0 million in a private placement of our common stock and warrants. The proceeds were raised for working capital purposes. In June 2003, we extended our credit facility with IBM Credit to August 2004 from August 2003 and lowered the interest charges on the debt from prime rate plus 4.25% to prime rate plus 1.75%. On July 3, 2003, the Company raised an additional $4.9 million by issuing subordinated secured convertible notes and warrants to one of its existing lender groups. The proceeds are being used to pay down the IBM credit facility and for working capital purposes. On July 28, 2003, the company raised an additional $3.49 million aggregate gross proceeds in a private placement of our common stock and warrants. The proceeds were raised for working capital purposes. On August 29, 2003, the Company entered into an agreement with Christopher J. Carey, by which it agreed to pay down amounts owed to Mr. Carey in equal monthly amounts of $316,666.67, plus interest, beginning September 2003 and ending February 2004. At its option, the Company may pay such monthly amounts in cash or in shares of the Company's common stock determined using a five day average prior to the monthly payment date. The agreement with Mr. Carey also requires the Company to register the shares of common stock issuable to Mr. Carey. Management continues to seek to replace our working capital financing line and raise additional permanent capital to support our growth in business. However, management believes that if it is unable to replace our working capital financing line and raise additional capital, it may not be able to continue as a going concern. IBM Credit, the Company's working capital lender, has notified the Company that it does not intend to renew its working capital line beyond August 2004 (see Note 6 of the Notes to the Condensed Consolidated Financial Statements). As a result, the company is seeking replacement financing for its credit facility. [Emphasis supplied.]
34
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84.
The statements in the Form 10-Q set forth in the preceding paragraph were false
and misleading when made for the following reasons: (a) The statements that As a result of the increase in demand for our services and the cost reduction measures initiated over the past two years, we achieved profitability during the fourth quarter of fiscal 2002 and during fiscal 2003 were materially false and misleading because they (i) failed to disclose that the 2003 results were based on extensive pre-invoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting its semi-monthly payroll and its bills from Datatecs vendors with fraudulentlyobtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills. The statements that We expect to be profitable throughout fiscal 2004 lacked any reasonable basis and were materially false and misleading because they (i) failed to disclose that the guidance was based on continuing and increasing Defendants improper practice of extensive pre-invoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting and could only continue to meet its semi-monthly payroll and its bills from Datatecs vendors with fraudulently-obtained accounts receivable financing. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills, and knew, or recklessly disregarded that the revenue and earnings guidance had no basis in reality. The statements regarding Datatecs liquidity were false and misleading because they did not reveal that Datatec was resorting to fraudulent invoicing to obtain financing in order to meet payroll and vendor bills, and that the Companys liquidity problems were thus actually worse than portrayed in the Form 10-Q. The same Form 10-Q also contained a chart purporting to summarize Datatecs
(b)
(c)
85.
defaults of its financial covenants (e.g., net profit to revenue and annual revenue to working capital ratios) under the IBM Credit facility, for each fiscal quarter, beginning in the fiscal quarter ended as of January 31, 2001, which IBM Credit had waived. For instance, the chart
35
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listed the same financial covenants with which Datatec had failed to comply for quarters ending in 2003 which are listed in 61 of this Complaint, plus the following additional item: Period July 31, 2003 Covenant Net profit to revenue Requirement Equal to or greater than 0.10% Actual (0.05%)
The introductory material to the chart in the Form 10-Q explained that: The Company and IBM Credit entered into an Acknowledgement, Waiver and Amendment to the Inventory and Working Capital Financing Agreement as of the end of each quarter since January 31, 2001 by which IBM Credit has waived the Companys defaults. Following the chart, the Form 10-Q advised that: IBM Credit, the Companys working capital lender, has notified the Company that it does not intend to renew its working capital line beyond August 2004. As a result, the Company is seeking replacement financing for its credit facility. 86. The statements in the introductory material and chart and following the chart,
referenced in the preceding paragraph were materially false and misleading when made for the following reasons: (a) The default ratios for items involving revenues (such as annual revenue to working capital and net profit to revenue) summarized in said chart were more serious than stated, because Defendants had caused Datatec to recognize substantial revenues well prior to work being performed, pursuant to Defendants undisclosed phantom invoicing scheme. The statement that IBM had waived the Companys defaults with its financial covenants and would not renew beyond August 2004 failed to disclose that Defendants had caused Datatec to engage in a pervasive fraudulent invoicing scheme, which, if known to IBM, would in all likelihood result in IBMs refusal to continue waiving Datatecs defaults with its financial covenants, and result in the termination of the accounts receivable financing upon which the Company was dependent for meeting payroll and vendor bills sooner than August 2004. 36
(b)
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87.
On September 26, 2003, Defendants issued the following press release, touting its
Asset Guardian product and a business partnership purportedly entered into for the purpose of enhancing Datatecs Asset Guardian Service, as follows: [Datatec] entered into a partnership with Network Physics to accelerate and simplify enterprise deployments of advanced network services such as IP Telephony, Wireless and Virtual Private Networking (VPN). Datatec will utilize the Network Physics NP/BizFlow product as a cornerstone for its Day 2 Asset Guardian service, and Network Physics has selected Datatecs Millennium Care division as its service desk partner for frontline help desk operations, providing tier one support for Network Physics customers. Datatecs Asset Guardian service focuses on the monitoring, maintenance, and administration of critical network services. Network Physics will provide three vital capabilities to Datatecs Asset Guardian service: -- end-to-end service visibility from an end-user perspective -- business impact alerting that identifies which business users and what applications are affected by network performance issues -- rapid problem resolution for hard failures and hard-to-find performance degradations. Understanding the ongoing performance of your key assets is an integral part of the operations and maintenance of todays IT environments, said Michael Lazar, Datatec Vice President of Technology and Development. By adding Network Physics as an offering to our Asset Guardian service, we can measure in real-time the key performance indicators (KPIs) of an enterprises most strategic assets, including business critical applications and vital network connections across WAN, LAN, VPN, wireless, and Internet telephony deployments. The Network Physics product provides the right mix of end-to-end business application performance and deep network visibility to capture the end user experience and truly manage inside the network cloud. The synergy between Datatec and Network Physics drove us to select Datatec as our frontline Help Desk delivery partner, said David Jones, President and CEO of Network Physics. Both Datatecs and Network Physics customer bases are facing enormous challenges in the 37
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deployment (Day 1) and management (Day 2) of critical new network initiatives. Asset Guardians seamless approach to the full service chain made Datatec a natural choice as our Level One service desk partner for 24 x 7 customer support. 88. The statements in the preceding paragraph were materially false and misleading
when made for the following reasons: (a) The statement that Datatecs Asset Guardian service focuses on the monitoring, maintenance, and administration of critical network services was materially false and misleading because the Asset Guardian software was essentially pie in the sky and therefore could not focus on or otherwise assist with monitoring maintenance and administration of critical network services. Defendants knew, or recklessly disregarded, that the Asset Guardian software did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. Similarly, the statement that By adding Network Physics as an offering to our Asset Guardian service . . . falsely and misleadingly implied that Asset Guardian was a functional service to which additional capabilities were being added. Defendants knew, or recklessly disregarded, that the Asset Guardian software did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. On October 21, 2003, Datatec held its Annual Shareholders= Meeting for the year
(b)
89.
ended April 30, 2003. In pertinent part, Defendant Gaon made the following disclosures with respect to Datatec=s prospects for fiscal 2004: Finally, on the issue of growth, we believe Asset Guardian will start to make a contribution to top and bottom lines by the fourth quarter of this year. We expect to have a prototype of the product by the middle of November when beta testing will commence. The general launch to the market will take place mid January to early February 2004. This software product has truly unique capabilities that will allow companies to capture, manage, monitor, analyze and account for all their assets from cradle to grave. This development is a mammoth undertaking for a company of our size and limited resources, but our development team is rising to the occasion and I have every faith that 38
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they will meet or exceed all our expectations. . . . We will be providing the product primarily through an ASP hosting offering thereby making it affordable and easy to license for CAPEX restricted organizations and it will also provide Datatec with an increasing recurring and very high margin revenue stream. The product is also positioned to be deep rather than wide in applications, therefore providing greater practical assistance to management thereby allowing for a quick payback and significant R.O.I. . . Institutional investors would understand where we are in our lifecycle and I think would be excited about our prospects especially now with our imminent launch of Asset Guardian. However, following the meltdown of the market in 2000/2001 and the subsequent dislocation of our business, we have not reached out to attract institutional support as we had much to do internally to get our business back on a sound footing. With operating performance and our balance sheet now both on firmer ground and economic prospects looking somewhat brighter although still very fragile, I believe the time is right to proceed with a program to increase the share of institutional holdings in our stock, which is currently very small. To help us with this effort and the launch of Asset Guardian, we will be engaging both an IR and PR firm. In summation, I believe we are taking all the right steps to position this company to take full advantage of the technology recovery which many have anticipated is finally upon us and appears to have some greater momentum to it this time round. 90. The statements in the preceding paragraph were materially false and misleading
when made for the following reasons: (a) The statement that Asset Guardian has truly unique capabilities that will allow companies to capture, manage, monitor, analyze and account for all their assets from cradle to grave was materially false and misleading because the Asset Guardian software was essentially pie in the sky and did not have any of the unique capabilities which Defendants claimed it had. Defendants knew, or recklessly disregarded, that the Asset Guardian software did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. Similarly, the statements that We expect to have a prototype of the product by the middle of November when beta testing will commence and The general launch to the market will take place mid January to early 39
(b)
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February 2004 and the statement referring to the imminent launch of Asset Guardian falsely and misleadingly implied that Asset Guardian was close to a launch as a functional service. Defendants knew, or recklessly disregarded, that the Asset Guardian software did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. (c) In addition, the statements that We believe Asset Guardian will start to make a contribution to top and bottom lines by the fourth quarter of this year had no basis in reality, and falsely and misleadingly implied that Asset Guardian was close to a launch as a functional service. Defendants knew, or recklessly disregarded, that the Asset Guardian software could not and would not contribute to Datatecs revenues, did not work and was not achievable without a commitment of resources far in excess of anything Datatec was capable of, and that Datatec had no viable plan for the development, financing and commercialization of the Asset Guardian software. The statement that operating performance and our balance sheet [are] now both on firmer ground was false and misleading because they (i) failed to disclose that Datatecs financials were based on extensive pre-invoicing and improper recognition of revenues for work which was not performed when invoiced, and (ii) failed to disclose that Datatecs finances were so dire that the Company was meeting its semi-monthly payroll and its bills from Datatecs vendors with fraudulently-obtained accounts receivable financing, and (iii) failed to disclose that Datatecs finances were continuing to worsen and were clearly not on firmer ground. Defendants directed and knew about, or recklessly disregarded, the Companys pre-invoicing to bolster revenues. In addition, Defendants were directly involved with obtaining such fraudulent financing in order to meet payroll and vendor bills to an ever-increasing extent. On December 5, 2003, Datatec filed a Form S-3 Registration Statement (File No.
(d)
91.
333-110935) to reregister the shares that had previously been registered as alleged above, namely: 8,226,247 shares declared effective July 31, 2003 (File No. 333-107502); 9,546,250 shares declared effective 10/30/03 (File No. 333-107502); 8,071,611 shares declared effective 11/26/03 (File No. 333-108737).
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92.
On December 5, 2003, in a partial revelation of the truth, Datatec unexpectedly
announced that Gaon had stepped down as Chairman and CEO, and that Mark Berenblut had resigned as a board member. According to Datatec, Gaon would be replaced by Raul Pupo as Chief Executive Officer. The Company said it was Afinalizing the terms of [Pupo=s] employment, and thus implying that the executive search to replace Gaon had begun substantially earlier. Datatec also retracted its previously-announced earnings estimates for fiscal year 2004 and instead stated that it expected a net loss for the second quarter of fiscal 2004 and an overall loss for all of fiscal 2004. Datatec=s stock price dropped 34%, from $1.16 on December 4, 2003 to close at $0.77 on December 5, 2003. 93. The Class Period ended on December 16, 2003. Before the opening of trading on
December 17, 2003, Datatec announced the extent of its earnings retraction: Datatec Systems, Inc. (Nasdaq: DATC), a leading provider of technology deployment software, services and post-implementation customer care solutions, today announced that it expects the loss for the fiscal quarter ended October 31, 2003 to be approximately $10 million. The Company also intends to take a restructuring charge of approximately $4.5 million in the following fiscal quarter in connection with its decision to eliminate the commercialization of certain software applications and to refocus the business on its core strengths of configuration and deployment. The Company also announced that it will delay the filing with the Securities and Exchange Commission of its Quarterly Report on Form 10-Q for the fiscal quarter ended October 31, 2003 and has decided, through its Audit Committee, to hire outside counsel to conduct an independent review of the valuation of long-term contracts. (Emphasis added). 94. Datatec =s stock price dropped another 15% on the news from $0.68 in the prior
day=s trading to close at $0.58 on December 17, 2003 on extremely heavy volume of 2,348,000
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shares compared to the average daily volume of Datatec stock for the prior 3 months which was approximately 908,863 shares. Relevant Post-Class Period Events 95. Throughout the class period, Datatec was not in compliance with certain required
covenants under its credit facility with IBM Credit. On December 18, 2003, Datatec filed a Form 8-K with the SEC disclosing, among other things, that on December 12, 2003, IBM Credit informed Datatec that it would not provide the Company with a written waiver of Datatec=s default under its credit facility with IBM Credit, for the fiscal quarter ended October 31, 2003. The 8-K stated, in pertinent part, as follows: Default Upon Senior Securities The Company maintains a credit facility with IBM Credit in the amount of approximately $25 million. For the fiscal quarter ended October 31, 2003, the Company was not in compliance with certain required financial covenants, and as a result, the Company is in default of the credit facility with IBM Credit. Since the fiscal quarter ended January 31, 2001, through and including the fiscal quarter ended July 31, 2003, the Company has had similar financial covenant defaults. For each of these fiscal quarters, IBM Credit had provided to the Company a written default waiver. On December 12, 2003, IBM Credit informed the Company that it would not provide the Company with a written waiver for the fiscal quarter ended October 31, 2003. The Company also has outstanding $4.9 million Subordinated Secured Convertible Notes which were issued to funds managed by the Palladin Group L.P. Pursuant to certain cross-default provisions of these notes, the Company has defaulted on these notes, as a result of its default of the IBM Credit facility and failure to obtain a waiver from IBM Credit on such default. 96. On December 17, 2003, the new CEO Pupo held a conference call with analysts.
An individual investor on the call was furious with Datatec for giving positive earnings guidance to the public, only to announce a $10 million loss for the quarter. The investor wanted to know, 42
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in substance, how defendant Gaon could have given such guidance repeatedly to the public during the Class Period when the Company=s earnings were obviously headed toward the substantial losses the Company ultimately announced. Pupo was courteous to the investor, but was careful not to answer any of the questions about Gaon=s conduct. 97. On December 23, 2003, Datatec announced that the Nasdaq Listings
Qualification Department had notified the Company that it violated Marketplace Rule 4310(c)(14) by failing to file its Form 10-Q for the period ended October 31, 2003, and that consequently, the Company=s securities would be delisted from the Nasdaq Stock Market at the opening of business on December 31, 2003. 98. On January 21, 2004, the Company announced the appointment of two new
independent directors to the Datatec board, John W. Adams and Per-Olof Loof, to serve on the Audit Committee. 99. On October 20, 2004, Traxi LLC (Traxi) was retained by Datatec to examine
and understand the Companys business, and prepare financial information about Datatec for prospective buyers. On November 17, 2004, Traxi presented a confidential presentation to IBM Credit and the Palladin Group, L.P., which contained an Adjusted Statement of Operations covering Datatecs operations from 2001 through 2004. In the Adjusted Statement of Operations, Datatecs revenue for 2004 was reduced by approximately $10 million to write off unbilled revenue at April 30, 2004, and Datatecs revenue for 2003 was reduced by approximately $15 million (to $109.8 million) to reflect adjustments recorded in FY2004 which are believed to relate to FY2003. Traxis Adjusted Statement of Operations thus confirms that Datatecs revenues were materially over-stated during the Class Period.
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100.
On December 14, 2004, Datatec filed voluntary petitions for bankruptcy under
Chapter 11 of the Bankruptcy Code, in the District of Delaware. ADDITIONAL SCIENTER ALLEGATIONS 101. As alleged herein, Defendants acted with scienter in that Defendants directed and
participated in the fraudulent schemes described herein. As detailed herein, Defendants had actual knowledge, or at a minimum recklessly disregarded the fact that Datatec and Defendants engaged in the phony invoicing and phantom products schemes detailed herein. Among other things, Gaon himself frequently called Company managers and ordered them to post phantom invoices to the Companys accounts receivable. Gaon was often overheard to say, We need to pre-bill $100,000 of the project today. Gaon also attended the vendor meetings which concerned getting funds to Datatecs vendors, who were threatening to cut off sending needed supplies to Datatec and Gaon resolved these difficulties by ordering more pre-invoicing. Gaon was also informed of the Companys inability to meet payroll, and also resolved these problems by ordering more pre-invoicing. Gaon was also advised by employees that the Asset Guardian software was not feasible with Datatecs limited resources. Despite this knowledge, Defendants touted the product, knowing full well that Datatec could not make the product functional or commercially feasible. 102. In addition, Defendants knew that the public documents and statements issued or
disseminated in the name of the Company were materially false and misleading; knew that such statements or documents would be issued or acquiesced in the issuance or dissemination of such statements or documents as primary violations of the federal securities laws. Defendants, by virtue of their receipt of information reflecting the true facts regarding Datatec, their control over, and/or receipt and/or receipt of information of Datatec=s allegedly materially misleading 44
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misstatements and/or their associations with the Company which made them privy to confidential proprietary information concerning Datatec, participated in the fraudulent scheme alleged herein. 103. In addition, Defendants were motivated to commit the fraud alleged herein -- and
in particular, Defendants use of the phony invoicing scheme detailed herein -- to maintain the Company=s financing from IBM Credit. The Company has had a history of limited working capital. As a result, it was critical to the survival of Datatec that the Company have sufficient accounts receivable in order to induce IBM Credit to extend financing, as well as to induce investors to purchase Datatec securities which were being offered during the Class Period. As of June 2003, Datatec had borrowed the maximum available under its credit facility with IBM Capital. According to Datatec, on April 14, 2003, IBM Credit agreed to amend the credit facility to: A(i) extend the expiration date of the facility to August 2004 from August 2003; (ii) provide a maximum availability of (a) $29 million until May 31, 2003; (b) $25 million until December 31, 2003; (c) $20 million until March 31, 2004; and (d) $15 million until August 1, 2004; (iii) lower the charges to prime plus 1.75% from prime plus 4.25% and (iv) alter certain financial covenants. (Form S-1A, filed 10/2/03). IBM Credit subsequently informed Datatec, at least as early as April 30, 2003, that it was Anot prepared to extend [Datatec=s] credit facility beyond August 2004. (SEC Form S-1A, filed 10/2/03). Defendants were motivated to engage in the fraudulent scheme alleged herein in order to conceal its viability in repaying its credit facility with IBM Credit. Through Defendants concealment of Datatec=s true financial condition, the Company was able to obtain waivers of its default from fiscal quarter ended January 31, 2001, through and including the fiscal quarter ended July 31, 2003 from IBM.
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104.
In addition, Defendants were motivated to engage in the fraudulent scheme
alleged herein in order to enable the Company to raise much-needed capital through the issuance of Subordinated Secured Convertible Notes and through newly issued common stock to institutional and other accredited investors, as detailed herein. In total, the Company was able to raise more than $13.39 million in proceeds. See Complaint 70, 71 and 74. 105. In addition, Defendants were motivated to engage in the fraudulent scheme
alleged herein to enable Datatec to pay vendors who were threatening to stop providing supplies, which would have closed down the Company, as detailed above. 106. Also, Defendants were motivated to continue the substantial compensation,
bonuses and perquisites they were receiving or due to receive from Datatec, inasmuch as publicly admitting that the Company was effectively insolvent and reliant on fraudulentlyobtained financing would end all of these substantial benefits. Defendant Gaons employment agreement (which commenced on May 1, 2003 and was originally scheduled to end on April 30, 2006) provided him with a $400,000 base salary plus consumer price index adjustments; a cash incentive bonus based on Datatecs net consolidated after-tax profits; a cash incentive bonus based on cumulative stockholder return; a discretionary cash incentive bonus; stock options; and medical, life, health, dental and disability insurance, among other perquisites. VIOLATIONS OF GAAP AND SEC REPORTING RULES Improper Revenue Recognition 107. During the Class Period, Defendants materially misled the investing public,
thereby inflating the price of the Companys common stock, by publicly issuing false and misleading statements and omitting to disclose material facts necessary to make Defendants statements, as set forth herein, not false and misleading. These statements and omissions were 46
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materially false and misleading in that they failed to disclose material adverse information and misrepresented the truth about the Company and the accounting, reporting, and financial condition of the Company in violation of the federal securities laws and GAAP. 108. The GAAP provisions violated by Defendants, and discussed in detail below,
were not new or untested provisions of GAAP and did not involve complex accounting issues. Additionally, Defendants committed these GAAP violations repeatedly, both before and during the Class Period. 109. The true nature of Defendants revenue recognition practices were not revealed
during the Class Period. According to information related by Plaintiffs confidential sources set forth in this Complaint, Datatecs improperly recognized revenues consisted of estimated revenues on estimated, not-yet-performed future work, which were recognized contrary to Defendants stated revenue recognition policies. 110. The SEC requires that publicly traded companies present their financial
statements in accordance with GAAP. 17 C.F.R. 210.4-01(a)(1). GAAP consists of those principles recognized by the accounting profession as the conventions, rules, and procedures necessary to define accepted accounting practices at the particular time. Regulation S-X, to which the Company is subject as a registrant under the Exchange Act, 17 C.F.R 210.401(a)(1), 65 provides that financial statements filed with the SEC that are not prepared in compliance with GAAP are presumed to be misleading and inaccurate. Accounting Series Release (ASR) 4, codified at SRA 34. 111. As set forth in Financial Accounting Standards Board (FASB) Statement of
Financial Accounting Concepts (SFAC) No. 1, one of the fundamental objectives of financial
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reporting is to provide accurate and reliable information concerning an entitys financial performance during the period being presented. SFAC No. 1, 42 states: Financial reporting should provide information about an enterprises financial performance during a period. Investors and creditors often use information about the past to help in assessing the prospects of an enterprise. Thus, although investment and credit decisions reflect investors and creditors expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of enterprise performance. 112. like Datatec: devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that - * * * Additionally, Section 13 of the Exchange Act requires, in part, that companies
transactions are recorded as necessary (i) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and (ii) to maintain accountability for assets; 15 U.S.C. 78m(b). 113. Defendants representations that Datatecs financial statements were prepared in
accordance with GAAP were materially false and misleading because, as alleged in this Complaint, Defendants: (1) engaged in the fraudulent revenue recognition practices detailed in this Complaint, which materially overstated the Companys reported revenues, accounts receivable and other financial results; (2) failed to disclose material trends in sales and invoicing practices that would have a significant, adverse effect on future results; and (3) failed to disclose the lack of internal controls necessary to ensure that work which was not performed was not improperly booked. Each of these misrepresentations, material omissions and fraudulent
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revenue recognition practices, standing alone, was a material breach of GAAP, applicable SEC regulations and the Companys own accounting policies. 114. Under GAAP, revenue should not be recognized until it is both earned and
collectible. SFAC No. 5, 83-84. These paragraphs indicate the following: 83. Further guidance for recognition of revenues and gains is intended to provide an acceptable level of assurance of the existence and amounts of revenues and gains before they are recognized. Revenues and gains of an enterprise during a period are generally measured by the exchange values of the assets (goods or services) or liabilities involved, and recognition involves consideration of two factors (a) being realized or realizable and (b) being earned, with sometimes one and sometimes the other being the more important consideration. Realized or realizable. Revenues and gains generally are not recognized until realized or realizable. Revenues and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. Readily convertible assets have (i) interchangeable (fungible) units and (ii) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price. Earned. Revenues are not recognized until earned. An entity's revenueearning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. Gains commonly result from transactions and other events that involve no "earning process," and for recognizing gains, being earned is generally less significant than being realized or realizable. In recognizing revenues and gains: The two conditions (being realized or realizable and being earned) are usually met by the time product or merchandise is delivered or services are rendered to customers, and revenues from manufacturing and selling activities and gains and losses from sales of other assets are commonly recognized at time of sale (usually meaning delivery). 49
a.
b.
84. a.
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b.
If sale or cash receipt (or both) precedes production and delivery (for example, magazine subscriptions), revenues may be recognized as earned by production and delivery. If product is contracted for before production, revenues may be recognized by a percentage-of-completion method as earnedas production takes placeprovided reasonable estimates of results at completion and reliable measures of progress are available. If services are rendered or rights to use assets extend continuously over time (for example, interest or rent), reliable measures based on contractual prices established in advance are commonly available, and revenues may be recognized as earned as time passes. If products or other assets are readily realizable because they are salable at reliably determinable prices without significant effort (for example, certain agricultural products, precious metals, and marketable securities), revenues and some gains or losses may be recognized at completion of production or when prices of the assets change. Paragraph 83(a) describes readily realizable (convertible) assets. If product, services, or other assets are exchanged for nonmonetary assets that are not readily convertible into cash, revenues or gains or losses may be recognized on the basis that they have been earned and the transaction is completed. Gains or losses may also be recognized if nonmonetary assets are received or distributed in nonreciprocal transactions. Recognition in both kinds of transactions depends on the provision that the fair values involved can be determined within reasonable limits. If collectibility of assets received for product, services, or other assets is doubtful, revenues and gains may be recognized on the basis of cash received.
c.
d.
e.
f.
g.
SFAC No. 5, 83-84. 115. For companies like Datatec that sell mostly services, revenue is recognized when
the services are received and accepted by Datatecs customers. As detailed herein, Defendants violated GAAP by repeatedly causing Datatec to recognize revenue for services which were not yet performed and billable.
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116.
These same straight-forward accounting principles were reflected in Datatecs
own stated revenue recognition policy. Datatecs 2003 Form 10-K represented the Companys revenue recognition policy as set forth in paragraph 59 of this Complaint. Datatecs Form 10-Q, for the period ending July 31, 2003, set forth the Companys revenue recognition policy as set forth in paragraph 81 of this Complaint. 117. As detailed herein, Defendants repeatedly caused Datatec to violate both GAAP
and its own revenue recognition policies by repeatedly recognizing revenue before products were shipped or services rendered, and/or where the purchaser had not yet been billed and had no fixed payment obligation; the products or services had not been delivered; or collectibility was not reasonably assured. 118. In addition, the recognition of assets, that is accounts receivable, was in direct
violation of GAAP, because such items did not meet the definition of assets contained in SFAC 6, 25-26. These paragraphs provide as follows: 25. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Characteristics of Assets 26. An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others' access to it, and (c) the transaction or other event giving rise to the entity's right to or control of the benefit has already occurred. Assets commonly have other features that help identify themfor example, assets may be acquired at a cost and they may be tangible, exchangeable, or legally enforceable. However, those features are not essential characteristics of assets. Their absence, by itself, is not sufficient to preclude an item's qualifying as an asset. That is, assets may be acquired without cost, they may be intangible, and although not exchangeable they may be usable by the entity in producing or distributing other goods or services. Similarly, although the ability of an entity to obtain benefit from an asset and to control others' access to it generally rests on a foundation of legal rights, legal enforceability of a claim to the benefit is not a 51
Case 2:04-cv-0052...