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A team of Philadelphia securities lawyers won a significant victory in the 1st U.S. Circuit Court of Appeals last week with a decision that revives a shareholders’ suit against A.T. Cross Corp., the Lincoln, R.I.-based maker of Cross pens. The unanimous three-judge panel found that the plaintiffs had a valid claim that the company’s revenues were fraudulently inflated even though Cross never issued financial restatements. The ruling in Aldridge v. A.T. Cross Corp. is a victory for attorneys Lawrence Deutsch and Shanon J. Carson of Berger & Montague, who argued that Cross made strongly optimistic statements about its new electronic notepad, the “CrossPad,” but failed to disclose several accounting and sales practices that hid the product’s poor performance in the market. Cross’ lawyers argued that because the company never restated any of its financials or otherwise indicated any error in its 1998 financial statements, and because its financial statements were audited by an independent accounting firm, no inference of accounting error, and therefore no inference of scienter, could be drawn. The court disagreed, saying it would not require plaintiffs in shareholders’ suits to submit proof of financial restatement in order to prove revenue inflation. “To hold otherwise would shift to accountants the responsibility that belongs to the courts. It would also allow officers and directors of corporations to exercise an unwarranted degree of control over whether they are sued, because they must agree to a restatement of the financial statements,” 1st Circuit Judge Sandra L. Lynch wrote. “The fact that the financial statements for the year in question were not restated does not end Aldridge’s case when he has otherwise met the pleading requirements of the Private Securities Litigation Reform Act.” According to court papers, Cross, which is best known for its line of fine pens and pencils, decided in the mid-1990s to counter its lagging sales by entering the personal electronic devices market by offering pen-based computing products through its Pen Computing Group. The CrossPad was unveiled in November 1997, and first shipped in March 1998. The CrossPad XP, a smaller model, was introduced in October 1998. Both devices were electronic note pads with digital pens, with which a user wrote on a note pad atop a battery-powered unit. The pens wrote on the paper in the traditional way and also recorded the pen strokes for later connection to a computer. Once the information was stored in a computer, it could be viewed, searched, and otherwise used. Cross had high hopes for its new product line and expressed those hopes publicly in September 1997 by saying it expected to report a minimum of $25 million in profitable sales for PCG in 1998. One of Cross’ officers compared its fledgling product to the highly successful Palm Pilot. But reality did not keep pace with the company’s projections. By late 1999 Cross had discontinued the CrossPad product line and suffered losses that year of $24.3 million, which essentially eliminated profits from the $24.8 million in sales on the PCG products in 1998. In April 2000, shareholder Michael Aldridge filed suit on behalf of anyone who purchased Cross common stock between Sept. 17, 1997, and April 22, 1999. The suit accused Cross of failing to disclose to investors that it had employed sales strategies — such as price protection, “take backs,” and “channel stuffing” — without reserving for them in financial statements, as they were obligated to do. In an April 22, 1999, press release, Cross had announced that the company’s sales had dropped dramatically from $9 million in the first quarter of 1998 to $1.1 million in the first quarter of 1999. On the same day, Cross’ management held a conference call with securities analysts and investors to discuss the company’s results for the first quarter of 1999. During the call, Russell Boss, president and CEO of Cross, explained that PCG sales had decreased in the first quarter “because of price protections.” He also mentioned “take backs” from customers. Robert Byrnes, president and CEO of PCG, also spoke about “price protection,” and said that the price reductions were part of the company’s original sales strategy. The news caused Cross’ stock to plunge below $4 per share. The shareholders claim that the April 1999 announcement was when they first learned of the price protection and take-back policy since Cross did not disclose any such plans or agreements in its public financial disclosures in 1998. The CrossPad product line was discontinued at the end of 1999 because of poor performance in the marketplace. Soon after, the company filed SEC forms in which shareholders say the company described for the first time a “revenue recognition” policy it had not disclosed earlier. In the form, Cross said: “Revenue from sales is recognized upon shipment or delivery of goods. Provision is made at the time the related revenue is recognized for estimated product returns, term discounts and rebates.” In the suit, Aldridge alleged that the statements made by the company and its management during 1998 and early 1999 were misleading in light of the company’s sales and accounting practices. But U.S. District Judge Mary M. Lisi of the District of Rhode Island dismissed the suit, finding that Aldridge had neither provided sufficient factual support for the allegations of fraud nor raised a strong inference of “scienter.” Now the 1st Circuit has reversed that decision, finding that Lisi failed to view the facts in the light most favorable to the plaintiffs. Lead plaintiffs’ attorney Deutsch said the ruling is significant because the 1st Circuit is considered among the most conservative on pleading standards for securities case under the PSLRA. The decision, Deutsch said, “may be signaling a new trend on the part of federal appeals courts to relax pleading standards in securities fraud actions alleging improper revenue recognition in the wake of the Enron scandal.” Judge Lynch, who was joined by 1st Circuit Judges Juan R. Torruella and Norman H. Stahl, wrote: “Although the pleading requirements under the PSLRA are strict … they do not change the standard of review for a motion to dismiss. Even under the PSLRA, the district court, on a motion to dismiss, must draw all reasonable inferences from the particular allegations in the plaintiff’s favor, while at the same time requiring the plaintiff to show a strong inference of scienter.” Lynch found that Lisi erred when she concluded that even if Cross made false statements or material omissions, there was no evidence that the company knew the statements or omissions were misleading at the time they were made. Instead, Lynch found that if the plaintiffs can prove their claims, they can show fraud. “Aldridge alleges that under generally accepted accounting principles (GAAP), with which Cross purported to comply, Cross was required to estimate a loss or range of loss and set a reserve with respect to all contingent sales that were made, including sales for which the buyer had the right to receive a credit or allowance if the price of the CrossPad declined before the buyer could resell the product (i.e., price protection),” Lynch wrote. “If Cross was unable to establish a reserve or estimate the loss, it was required to disclose the practices that gave rise to the contingent revenues and earnings. Aldridge alleges that the defendants knew that Cross had not sufficiently reserved for the losses that inevitably would occur when Cross was forced to honor its price protection commitments, and that their failure to disclose this to the public violated federal regulations … and accounting standards,” Lynch wrote. Cross’ lawyers argued that the claim was a garden-variety “fraud by hindsight” case, occasioned by the large drop in sales of CrossPad products after 1998. Lynch disagreed, saying “that characterization is off the mark. Fraud by hindsight occurs when a plaintiff simply contrasts a defendant’s past optimism with less favorable actual results, and then contends that the difference must be attributable to fraud. … In this case, on the other hand, Aldridge complains that the company failed to disclose certain known material information as to the contingent nature of the sales, and that Cross essentially admitted to the 1998 contingencies in 1999.” As a result, Lynch said, “the allegations of fraud in the complaint have sufficient factual support to survive a motion to dismiss.”

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