The opinion of the court was delivered by: Blackburn, J.
ORDER CONCERNING DEFENDANTS' MOTION TO DISMISS
The matter before me is Defendants' Motion to Dismiss Plaintiffs' Second Consolidated and Amended Complaint [#160], filed August 1, 2005. On August 25, 2004, I entered an order [#98] resolving the defendants' motion to dismiss the plaintiffs' consolidated amended complaint [#65], filed May 14, 2002. I granted the motion in part, and denied it in part. On July 18, 2005, the plaintiffs were granted permission to file their Second Consolidated Amended Complaint [#155]. The current motion to dismiss addresses the claims asserted in the Second Consolidated Amended Complaint, to which I will refer as the Complaint. Defendants move to dismiss this proposed class action federal securities fraud case for failure to state a claim on which relief can be granted.
I have jurisdiction over this case under 15 U.S.C. § 78aa (actions to enforce the federal securities laws) and 28 U.S.C. § 1331 (federal question).
When ruling on a motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6), I must determine whether the allegations set forth in the complaint, if true, are sufficient to state a claim within the meaning of Fed.R.Civ.P. 8(a). I must accept all well-pleaded allegations of the complaint as true. McDonald v. Kinder-Morgan, Inc., 287 F.3d 992, 997 (10th Cir. 2002). "However, conclusory allegations or legal conclusions masquerading as factual conclusions will not suffice to prevent a motion to dismiss." Fernandez-Montes v. Allied Pilots Association, 987 F.2d 278, 284 (5th Cir. 1993); see also Ruiz v. McDonnell, 299 F.3d 1173, 1181 (10th Cir. 2002) ("All well-pleaded facts, as distinguished from conclusory allegations, must be taken as true."), cert. denied, 538 U.S. 999 (2003). Thus, Rule 12(b)(6) requires dismissal if, taking all well-pleaded facts as true and construing them in the light most favorable to plaintiff, it is clear that he can prove no set of facts entitling him to relief. See Conley v. Gibson, 355 U.S. 41, 45-46 (1957); Rocky Mountain Helicopters, Inc., v. Bell Helicopter Textron, Inc., 24 F.3d 125, 128 (10th Cir. 1994).
The plaintiffs allege a claim for securities fraud under § 10(b) of the Exchange Act, 15 U.S.C. § 78(b), and Rule 10b-5, 17 C.F.R. §240.10b-5, and a claim for controlling person liability under § 20(a) of the Exchange Act,15 U.S.C. § 78t(a). The specialized pleading requirements of the Private Securities Litigation Reform Act of 1995 ("PSLRA"), Pub.L. No. 104-67, 109 Stat. 743 (codified at 15 U.S.C. §§ 77z-1, 77z-2, 78u-4, 78u-5, 77t, 78o, 78t & 78u) are applicable to the plaintiffs' claims. The defendants argue that the plaintiffs' allegations do not satisfy the requirements of the PSLRA.
The Tenth Circuit has concluded that the PSLRA has not "completely eviscerated our traditional Rule 12(b)(6) standard." Pirraglia v. Novell, Inc., 339 F.3d 1182, 1188 (10th Cir. 2003); see also In re Rhythms Securities Litigation, 300 F.Supp.2d 1081, 1084 n.1 (D. Colo. 2004). The court's role remains to determine whether the allegations set forth in the complaint, if true, are sufficient to state a claim. The complaint still must be construed in the light most favorable to the plaintiff, and its allegations must be taken as true. See Robinson v. City and County of Denver 39 F. Supp. 2d 1257, 1262-1263 (D. Colo. 1999) (citing Daigle v. Shell Oil Co., 972 F.2d 1527, 1533 (10th Cir.1992)).
However, because the PSLRA requires a plaintiff to plead facts giving rise to a "strong inference" of scienter, as well as to specify each statement alleged to be misleading and why it is misleading, the "'customary latitude granted the plaintiff under Rule 12(b)(6)" is modified as to these elements. Pirraglia, 339 F.3d at 1187 (quoting Gompper v. VISX, Inc., 298 F.3d 893, 896 (9th Cir. 2002)). Thus, to determine whether the complaint supports a "strong inference" of scienter, the court must consider all reasonable inferences, including those unfavorable to the plaintiff. Id. at 1188. Similarly, with respect to the requirement to specify the allegedly misleading statements underlying the plaintiff's claims, the court may not draw inferences in the plaintiff's favor if to do so would allow the plaintiff to make allegations without the required factual underpinnings. Id.
III. PROCEDURAL BACKGROUND
This lawsuit arises from the plaintiffs' allegations of securities fraud concerning the publically traded stock of ICG Communications, Inc. ("ICG"). The facts outlined below are taken from the plaintiffs' Complaint. I will refer to specific portions of the Complaint by paragraph (¶ 1).
Two defendants are named in the Complaint. J. Shelby Bryan served as ICG's President from May, 1995, until June 10, 1999; as Chief Executive Officer from May, 1995, until August 22, 2000; and as Chairman of ICG's Board of Directors from June, 1999, until August 22, 2000. William S. Beans, Jr., joined ICG in July, 1999, as Executive Vice President of Network Services, and served as ICG's President and Chief Operating Officer from January 1, 2000, until December 4, 2000. ICG filed bankruptcy on November 14, 2000, and a Chapter 11 plan of reorganization was approved by the Bankruptcy Court on October 10, 2002. The plaintiffs have not named ICG as a defendant in this case because its liabilities related to the plaintiffs' claims were discharged in ICG's bankruptcy. ¶ 31.
ICG was a telecommunications company. In the late 1990s, ICG decided to transform itself from a traditional provider of telecommunication lines for the transmission of voice data to an internet network services provider. ¶¶ 1, 38. Providing internet network services requires high speed, high capacity data transmission lines. ICG built its system of high speed networks at a rapid pace between 1996 and 1999. During this time the company's long-term debt grew from $400 million in 1995 to almost $2 billion by the end of 1999. By the time Beans joined ICG in July, 1999, ICG had planned to build a national data network. Execution of this plan would require the company to obtain significant financing. To obtain this financing Bryan and Beans knew that ICG would have to demonstrate to Wall Street and the investing community that ICG's business model, centered around large scale sales of internet data transmission lines, was working. ¶ 46. Wall Street measured ICG's business success by "line count," the number of revenue producing lines ICG had installed, and the revenues those lines produced as reported by ICG. Complaint, ¶ 39. A provider of internet data-transmission lines conceivably could report large growth in line count because data transmission lines for the internet often were ordered and installed by the tens or hundreds of thousands. Id.
According to the plaintiffs, Bryan and Beans made material and misleading statements, and failed to reveal material facts, concerning the state of ICG's business during the third quarter of 1999, and the first and second quarters of 2000. The alleged misrepresentations and concealment concerned three areas of ICG's business:
1) artificial inflation of line counts; 2) artificial inflation of reciprocal compensation revenue; and 3) non-disclosure of serious and continuing problems with ICG's communications network and customer service. The plaintiffs define the proposed plaintiff class as including all persons who purchased ICG common stock on the open market between December 9, 1999, and September 18, 2000. ¶ 181.
In their previous complaint, the Consolidated Amended Complaint [#65], filed February 15, 2002, the plaintiffs made similar allegations of securities fraud concerning these same three areas. On August 25, 2004, I entered an order granting the defendants' motion to dismiss certain claims asserted in the plaintiffs' Consolidated Amended Complaint (August 25, 2004, order). I briefly summarize below the claims that were dismissed in my August 25, 2004, order and the claims that survived the previous motion to dismiss.
Line Count - The plaintiffs' claims against Bryan related to the reporting of artificially inflated line counts were dismissed because the allegations in the Consolidated Amended Complaint did not indicate that Bryan took any action in response to the information revealed in ICG's line counts, that Bryan knew the line count numbers released in December, 1999, were false, or that Bryan was aware of other information indicating that ICG's reported line counts were false. August 25, 2004, order, pp. 17-18. The plaintiffs' claims against Beans concerning inflated line counts reported in March and June 2000, were dismissed because the plaintiffs did not allege that Beans' orders to create fictitious lines were carried out by ICG employees. August 25, 2004, order, p. 17, n.6. The motion to dismiss was denied as to the plaintiffs' claims against Beans concerning inflated line counts in the fourth quarter of 1999.
Reciprocal Compensation - The motion to dismiss was denied as to the plaintiffs' claims against Bryan and Beans concerning the reporting of reciprocal compensation revenue in the fourth quarter of 1999.
Network and Customer Service Problems - The defendants' motion to dismiss was granted as to the claims against both Bryan and Beans concerning the alleged failures to disclose customer complaints and network problems. These claims were dismissed because there was no "competent, non-conclusory allegation to support an inference that either Bryan or Beans knew of any such problems or complaints." August 25, 2004, order, p. 20.
The plaintiffs say they have provided significant additional factual details in the present Complaint, and argue that their allegations are sufficient to state claims on which relief can be granted in each of the three areas summarized above. The defendants argue that all of the plaintiffs' allegations still are insufficient to state claims for securities fraud against the defendants.
I will summarize below the plaintiffs' factual allegations which support their claims that Bryan and Beans made material misrepresentations of fact, and concealed material facts concerning three areas of ICG's business. Additional allegations are discussed in the analysis section of this order, Section V, below.
Shortly after joining ICG, Beans began to conduct weekly meetings to monitor ICG's progress in meeting Wall Street's expectations. ¶ 49. In addition, Bryan convened larger monthly meetings that lasted two hours or more, with at least the first 45 minutes devoted exclusively to ICG's line count. ¶ 50. Beans led these monthly meetings. Id. Bryan actively participated in the decision making process discussed at these meetings and signed off on all line count reporting practices. Id. The plaintiffs describe in the Complaint why they allege that line count was of particular importance at ICG during this time:
(B)y the fourth quarter of 1999, the technical problems with ICG's network threatened the lines that were already sold to the ISPs [internet service providers] and threatened ICG's ability to legitimately meet Wall street's expectations. As a result, these weekly executive meetings became focused almost exclusively on ways for the Company to artificially inflate its line count to meet or exceed Wall Street's line count expectations. ¶ 85.
The plaintiffs allege that ICG publically represented that it recognized revenue only on lines that were installed and revenue producing. ¶¶ 88-89. ICG's official line count was tabulated using ICG's DTOTS database. ¶ 96. By company policy this database was to include only lines that were installed and producing revenue. Id. Contrary to this policy, Bryan and Beans allegedly directed ICG employees to factitiously boost the lines tabulated in the DTOTS database, and, thus, the lines reported to be revenue producing, in several ways. At the direction of Bryan and Beans, ICG allegedly reported non-billable lines, cancelled lines, internal lines, uninstalled lines, "in" lines, "free" lines, and even non-existent lines as revenue producing lines. ¶¶ 96-99.
Non-billable lines were lines on which ICG would offer delayed billing or bargain rates to large customers if the customers would agree to take lines they did not need. ¶ 104. Bryan and Beans instructed Vince Dibiase, Senior Vice President of National Sales, to execute this plan. ¶ 104. Dibiase says ICG sold 6,000 to 10,000 lines each to NetZero and UUNet in the fourth quarter of 1999, knowing that installation would not be complete in that quarter, and that both companies would reject a substantial number of those lines prior to installation. Id. Delayed billing agreements were used also at the end of 1999 to sell lines in the fourth quarter, when the parties to the sale knew that the lines would be cancelled in the next quarter, and the customer would be credited. ¶ 106. Bryan was aware of this practice. Id.
In addition, ICG counted lines that the plaintiffs call ISP free lines. ¶ 128. According to the plaintiffs, ICG agreed to provide ISPs with one free line for every line the ISP purchased from ICG. Id. The second line was intended to ensure that ISP customers would not experience difficulties or delays when trying to call to the ISPs server via ICG's network. Id. Throughout the class period, ICG reported these free lines as revenue producing lines, causing ICG's line count to be inflated by as much as 25 percent. Id.
Cancelled lines also affected ICG's line count for the fourth quarter of 1999. At the end of that quarter, UUNet and Net Zero informed ICG that they had decided to cancel a significant portion of their order, requiring the removal of 6,000 to 10,000 lines from the official line count for that quarter. ¶ 107. Dibiase met with Beans and Bryan concerning the removal of these lines from the line count. Beans instructed Dibiase to "play dumb" and not to remove the lines from the line count until the first quarter of 2000. Beans told Dibiase that he wanted to wait to remove these lines from the line count so ICG's ability to meet Wall Street's expectations would not be affected. ¶ 108. Another ICG employee reported that ICG's year end 1999 line count was inflated by 30,000 to 50,000 lines largely because senior management directed staff not to disconnect cancelled lines until the following quarter. ¶ 109.
ICG also double-booked revenue from certain customers. ICG recognized revenue attributable to customers that it had switched over to the NETCOM network that ICG purchased in 1998, yet ICG continued to book monthly revenue from the same customers as if they still were using ICG's original frame relay network. ¶ 111. In May, 2000, ICG's Vice President of Finance, Richard Fish, discussed this practice with Beans, and Beans allegedly reported that Bryan had directed that the practice continue because it was necessary to meet Wall Street's expectations. ¶ 112.
Internal lines were lines installed at ICG's NETCOM subsidiary that did not produce revenue. In late December, 1999, Bryan and Beans approved the addition of these lines to the DTOTS database. ¶ 113. This practice affected ICG's line count for either or both the fourth quarter of 1999 and the first quarter of 2000.
Uninstalled lines were lines that were not yet installed and operating. During the first two quarters of 2000, Beans instructed ICG staff to add uninstalled lines to the DTOTS database. ¶ 115. Beans allegedly ordered that these lines be recognized in the database because they were necessary to meet Wall Street's line count expectations. This practice significantly affected ICG's reported line count in the fourth quarter of 1999, and the first quarter of 2000. ¶¶ 115-118.
Non-existent lines are, in essence, lines that never were sold or installed, but which were represented in the DTOTS database and reported as revenue producing lines. To inflate ICG's line count, Beans allegedly instructed ICG's technical consultants in the weeks before the end of fourth quarter 1999 to "create lines," which they did. ¶¶ 91-93. ICG thereby reported revenue on lines that had not actually been installed. ¶ 89. Beans allegedly directed employees to fabricate line orders during the first and second quarters of 2000 as well. One week before the end of the first quarter of 2000, Beans held an "all hands" meeting in ICG's provisioning center. ¶ 119. Beans stated that ICG was 106,000 lines short of its quarterly objective. Id. Immediately after this meeting, Beans met with ICG's Provisioning Director and its Vice President of Provisioning. Id. Thirty minutes after this meeting, employees could hear the ICG wholesale group being told to write orders for 25,000 to ...