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Finding that investors in CDNow Inc. had no right to know in advance that the company’s proposed merger with Columbia House wasn’t likely to go through because that fact wasn’t certain until the “drop dead” date, a federal judge has dismissed a class action securities fraud suit. Senior U.S. District Judge Marvin Katz also ruled that CDNow didn’t deceive investors by allegedly failing to disclose that an independent auditing firm was planning to release a report that questioned CDNow’s ability to remain a “going concern” for another year because that fact, too, wasn’t certain until the report was issued. Since neither fact was a certainty, Katz ruled that the company had no “duty to disclose” them. “A corporation is not required to disclose a fact merely because a reasonable investor would like to know that fact. Rather, an omission is actionable under the securities law only when the corporation is subject to a duty to disclose the omitted fact,” Katz wrote in his 33-page opinion in In Re: CDNow Inc. Securities Litigation. Katz also found that “both of these omissions are immaterial because they concern speculative and contingent events.” The ruling is a victory for attorneys Marc J. Sonnenfeld and Karen Pieslak Pohlmann of Morgan Lewis & Bockius, who also successfully argued that the lawsuit failed to meet the heightened pleading standards of the Private Securities Litigation Reform Act or the “specificity” requirements for pleading fraud under Rule 9(b) of the Federal Rules of Civil Procedure. According to the suit, CDNow’s proposed merger with Columbia House — which is equally owned by Sony and Time Warner — would have formed a new company owned 26 percent by CDNow shareholders, 37 percent by Sony, and 37 percent by Time Warner. Columbia House and CDNow were to become wholly owned subsidiaries of the new company. In July 1999, CDNow, Sony and Time Warner jointly announced they were considering the merger. But in January 2000, the suits alleged, CDNow’s independent auditor, Arthur Andersen, expressed “serious doubt” about CDNow’s ability to remain a viable entity. Investors say CDNow failed to disclose the auditor’s concerns to the public and violated the merger agreement by failing to disclose the fact to its would-be partners at Sony and Time Warner. Instead, the suits allege, CDNow misled investors by stating only that its fourth-quarter financial results for 1999 were the strongest ever and by treating the proposed merger as if it were still going smoothly. On March 13, 2000 — the “drop dead” date for the merger — the public learned some of the bad news when the three companies announced that the merger was canceled. But investors said they still did not get the whole truth since the explanation given at the time was that Columbia House was in poor financial condition. In fact, the investors said, Columbia House’s financial condition was not the sole reason the merger was called off, and CDNow was left in a precarious position in which it would be sold at a “bargain basement” price in any later merger. Now Katz has dismissed the entire case, finding that “as a matter of law, defendants are not liable for failing to inform the public that the merger would not go through.” Katz found that the merger termination was not certain until March 13 and that the defendants therefore “had no duty to inform the public that the deal was dead prior to that date.” But plaintiffs’ lawyers argued that CDNow’s top officers knew that the merger was going to fail prior to the public announcement. Katz disagreed, saying the claim was based on “unsupported and conclusory allegations.” “In arguing that defendants’ knowledge was certain, the plaintiffs ignore that the success or failure of the merger was also dependent on two other companies — Sony and Time Warner — making their own evaluations of the transaction’s desirability,” Katz wrote. “Plaintiffs do not suggest in their pleadings that the other parties to the transaction viewed the deal as dead prior to March 13; the court, therefore, does not accept plaintiffs’ allegation that the merger’s termination was certain before the agreement’s drop dead date,” Katz wrote. “The limited factual allegations in the complaint regarding the role of Sony and Time Warner suggest that the likelihood of the merger’s success was not something that CDNow could independently ascertain or publicize until the drop dead date.” The plaintiffs also claimed that once Andersen had completed its 1999 audit of CDNow, the plaintiffs said, the company knew it could not survive — and that Andersen would issue the “going concern” qualification — unless it merged with another entity. By Feb. 13, 2000, the suit alleged that CDNow executives knew the merger could not be consummated because Columbia House’s cash flow, combined with CDNow’s true financial condition, could not support the merged entity. Despite knowing that the merger would not occur — and that it had no available option that would avoid a “going concern” qualification by Andersen — the suit alleged that CDNow chose to keep its financial crisis quiet while investors continued to pour money into CDNow shares. And even after the merger was terminated, the suit said, CDNow President and CEO Jason Olim and Vice President and CFO Joel Sussman made materially misleading statements that “continued to mislead the public into believing that the termination was beneficial to CDNow and that it could survive in its existing financial condition.” But Katz found that investors already knew that CDNow was in financial trouble as a result of its public release of 1999 financial statements on Feb. 3, 2000. In a press release, the company reported a net loss of $25.7 million for the fourth quarter and a $119.2 million net loss for the year 1999. Figures for the preceding two years revealed that the company had a working capital deficit of $32.7 million by the end of December 1999; that over the past year, its cost of sales increased 161 percent, from $45.35 million in 1998 to $118 million in 1999; and that its overall operating expenses nearly tripled, from over $57 million in 1998 to $150.7 million in 1999. “If nothing else,” Katz wrote, “[the figures] reveal to a reasonable investor that CDNow was in serious need of positive cash flow. Thus, the investing public already had information, independent of Olim’s statements, that suggested that CDNow’s condition was such that it required a strong merger partner.” In July 1999, when the merger was announced, CDNow’s stock price was $22-1/4 per share. Its stock price on March 10, 2000 — the last trading day before the merger cancellation announcement — was $9-7/16 per share. The price had dropped to $6-31/32 per share by close of trading on March 14, 2000. The price dropped again to its 52-week low of $3-1/2 per share closing price on March 29, 2000, the day after Andersen’s going concern qualification was filed with the SEC. Katz found that CDNow also had no duty to disclose that it might receive a “going concern qualification” prior to Andersen’s issuing one. “Plaintiffs’ assertion that the defendants knew that a going concern qualification was inevitable prior to the date it was actually issued is an unsupported allegation that ignores that the final decision regarding the qualification rested with Andersen,” Katz wrote. But Katz also made clear that his ruling was limited to the facts before him. “The court does not mean to suggest that there can never be an instance where a company’s financial prognosis is so grim that it becomes clear that the company is unlikely [to] continue as a going concern before the auditors have officially announced the death knell. In view of the facts and circumstances alleged in this case, however, the court holds as a matter of law that Andersen’s going concern qualification was not certain until the auditors issued their report,” Katz wrote. In an important final section of the opinion, Katz ruled that an alternative ground for dismissing the entire case was its failure to meet the heightened pleading standards of the PSLRA and Rule 9(b). For the same reasons he had laid out in the first parts of the opinion, Katz found that the suit also “lacks non-conclusory and supported allegations that the merger was certain to terminate before March 13 and that Andersen would inevitably decide to issue the going concern qualification before March 16.” He also found that the plaintiffs failed to plead “scienter” adequately to meet the 3rd Circuit’s test that calls for “facts that constitute circumstantial evidence of either reckless or conscious behavior” or “alleging facts establishing a motive and opportunity to commit fraud.” Lead counsel for the plaintiffs was attorney Jill S. Abrams of Abbey Gardy & Squitieri in New York, along with Lawrence Fenster of Ross & Hardies, also in New York, and Deborah Gross of the Law Offices of Bernard Gross as liaison counsel.

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