Violations of the 1934 Act. To comply with accounting principles, a company that engages
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Violations of the 1934 Act. To comply with accounting principles, a company that engages in software development must either “expense” the cost (record it immediately on the company’s financial statement) or “capitalize” it (record it as a cost incurred in increments over time). If the project is in the pre- or post-development stage, the cost must be expensed. Otherwise it may be capitalized. Capitalizing a cost makes a company look more profitable in the short term. Digimarc Corp. announced that it had improperly capitalized software development costs over at least the previous eighteen months. The errors resulted in $2.7 million in overstated earnings, requiring a restatement of prior financial statements. Zucco Partners, LLC, which had bought Digimarc stock within the relevant period, filed a suit in a federal district court against the firm. Zucco claimed that it could show that there had been disagreements within Digimarc over its accounting. Is this sufficient to establish a violation of SEC Rule 10b-5? Why or why not? [ Zucco Partners, LLC v. Digimarc Corp ., 552 F.3d 981 (9th Cir. 2009)] (See Securities Exchange Act of 1934 .) |
Explanation
The announcement by Digimarc of the improper capitalization of software costs demonstrates an effort to be forthright with its stockholders and demonstrates a lack of intent to defraud its stockholders.
The court found that evidence of a profit motive and disagreement about accounting standards within Digimarc Corp. did not support Zucco Partners' claim that Digimarc recklessly disregarded the accuracy of its financial statements. As a result, Zucco's complaint does not sufficiently allege that Digimarc's misstatements were made with the intent to defraud, as is required for a violation of SEC Rule 10b-5.
The Zucco Partners case demonstrates that even if a firm is in violation of Rule 10b-5 at the time of the statement, prosecution will be unsuccessful if the firm can demonstrate that the statement was made in good faith and without any evidence of scienter.
The court ruled in favor of Digimarc because Zucco Partners was unable to demonstrate that the company's statements were false or misleading. Furthermore, there was no evidence that the accountants at Digimarc were aware that they were providing false information. As a result, this company did not act with fraudulent intent.
In addition, the Supreme Court's decision may not be used in support to a claim against an individual issuer (such as Digimarc) if there are no allegations that the defendant assisted another person in committing a securities fraud. Instead, Zucco could have filed a claim under Section 10(bRule )'s 10b-5 for aiding and abetting. In order for such a claim to be valid, there must be an allegation that Digimarc knowingly and substantially contributed to the fraudulent conduct on behalf of another party.
Section 10(b) does not prohibit all fraudulent schemes. The rule is intended to prohibit "a specific type of fraud" known as misrepresentations or nondisclosures made in the buying or selling of securities. The Court of the United States has interpreted this language to establish a three-part test:
There must be a "material misrepresentation or omission by defendants", who are responsible for disclosing; • Defendants must have acted with scienter, which is defined as "an intent to deceive, manipulate, or defraud." In other words, it was reasonably foreseeable that the plaintiffs would rely on the defendants' actions, and the plaintiffs did in fact rely on such actions when deciding whether or not to trade in the defendant's securities.
Answer
Digimarc Corp. did not violate SEC Rule 10b-5. The SEC rule requires that there is "scienter" or intent to commit a fraudulent act.
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