Full opinion text
OPINION AND ORDER GRANTING DEFENDANTS’ MOTIONS TO DISMISS ROSEN, District Judge. I.INTRODUCTION On October 7, 1996, Plaintiffs Fred S. Havenick, George L. Leland, and Jacquelyn Leland filed this class action on behalf of themselves and other purchasers of the stock of Defendant Network Express, Inc. (“NEI”) between March 13, 1995 and October 6, 1995 (the “Class Period”). NEI and the other Defendants in this action had the following relationships during the Class Period: 1. Defendant Richard P. Eidswick was NEI’s President and Chief Executive Officer; 2. Defendant David L. Hartmann was NEI’s Executive Vice President and Chief Technical Officer; 3. Defendant David J. Carson was NEI’s Vice President of Corporate Development; 4. Defendant Thomas C. Kinnear was a Director of NEI; 5. Defendant Brian Sullivan was a Director of NEI; 6. Defendant Stephen A. Swanson was a Director of NEI; and 7. Furman Selz, L.L.P. and Unterberg Harris, which are each an investment firm and a securities underwriter, co-managed a secondary offering on behalf of NEI. In their Complaint, Plaintiffs allege that during the Class Period, Defendants NEI, Eidswick, Hartmann, Carson, Kinnear, Sullivan, Swanson, Furman Selz, and Unterberg Harris made false and misleading representations and omissions regarding NEI’s business success which artificially inflated NEI’s stock price and then led to a precipitous decline once they disclosed more accurate information to the market. Accordingly, Plaintiffs’ Complaint includes the following Counts: (1) Violation of 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 U.S.C. § 78j(b), and Rule 10b-5,17 C.F.R. § 240.10b-5, against all Defendants; and (2) Violation of Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a), against NEI, Eidswick, and Hartmann. Pursuant to Fed.R.Civ.P. 12(b)(6), Defendants have moved to dismiss Plaintiffs’ Complaint, arguing that: (1) the applicable statute of limitations bars Plaintiffs’ claims; (2) the Complaint fails to identify any material misstatement or omission to support an actionable claim of securities fraud against any Defendant; and (3) the Complaint fails to plead scienter adequately. Moreover, Defendants contend that under Fed.R.Civ.P. 9(b) and 15 U.S.C. § 78u-4(b)(2), the Complaint fails to plead the circumstances of fraud with sufficient particularity. Having reviewed the parties’ pleadings and conducted a hearing on this matter, the Court is now prepared to rule. This Opinion and Order sets forth the Court’s ruling. II. FACTUAL BACKGROUND NEI sells integrated services digital network (“ISDN”) equipment for high-speed telecommunications. (Complaint, ¶ 1). In mid-1994, NEI became a public company, and by the end of January 1995, its stock was trading at approximately $7-$8 per share on the NASDAQ SmallCap Market. (Complaint, ¶ 29). Thereafter, on March 13, 1995, NEI issued a press release in which Hartmann described NEI’s customer base: Network Express customers range in size from relatively small shops to large government institutions, but they all share the same goals: to accurately transmit important data images in the fastest most cost-effective and secure manner possible ... [NEI] has over 3,000 installations in the US, Japan, and Europe. (Complaint, ¶ 32). At this time, NEI’s stock price had increased to over $15 per share. (Id.). A. The Corporate Background Document. On March 15, 1995, NEI announced a secondary public offering of over 2 million shares of its common stock, including stock offered by NEI and certain selling shareholders. (Complaint ¶ 33). At this time, and throughout the remainder of the Class Period, NEI distributed to the market a document entitled “Corporate Background.” (Complaint, ¶34). Under the “Company Overview” rubric, the following statements appear: NEI is a worldwide leader in the rapidly expanding market of... ISDN---- Utilizing its experience in the demanding Japanese market as a provider of routers and hubs for ISDN, NEI is expanding in the U.S. market, where the Regional Bell Operating Companies (RBOCs) are now deploying ISDN at a fast pace for applications such as telecommunicating, remote access, Internet access, and many more. ifc * * * * Hs The Company is the market leader in Japan, where it first introduced ISDN products in 1992. ISDN has been widely deployed in Japan for many years, and NEI opted to focus on proving its products in that highly quality-conscious market before moving broadly into the U.S. ISDN market. jj: í[í ‡ s{: As the RBOCs in the U.S. respond to customer demand and deploy ISDN on a wider scale, NEI will provide its proven alternative to slow and expensive conventional modem lines. (Complaint, ¶ 34). The Corporate Background document also discusses a new NEI product, the NELink1000: The newest addition to the NE Series, the NELink-1000 is an internetworking product designed for the small central site or remote office using ISDN for the exchange of data, graphic, and image files. The NELink-1000 fills two ISDN inter-networking needs. As a starter kit at a small central site, the NELink-1000 provides interoperability with the widest array of remote access products. Second, it can be used for multiple users needing remote access to one or more scaleable Network Express NE 2000 II’s, fOOO’s, or 5000’s at central cites. (Complaint, ¶ 35). Finally, the Corporate Background document provides information regarding NEI’s customers: NEI customers utilize the NEI ISDN Interhub and NE ISDN Router for a variety of complex networking and communications applications, including telecommuting, video-conferencing, and imaging. Select NEI U.S. customers include: Access Management Apple Computer Ameritech Bell Atlantic Cabletron Systems Circuit City Comnet EDP Communications Household International Internal Revenue Service Michigan State University Ncube New Jersey State College NYNEX Pacific Bell Real Time Communications San Fernando Valley of Realtors Silicon Graphics Stratacom University of Michigan U.S. Patent & Trade Office Amdahl Allenr-Bradley Bellcore Bell Northern Research Chrysler Corporation Cirrus Logic Department of Education Fujitsu Intel LSI Logic National Semiconductor Netscape Communications NIST (National institute of Standards and Technology) Perot Systems Ross & Hardies Sandia National Labs Standard & Poor Symantec U.S. Joint Chiefs of Staff U.S. Senate William Morris Agency (Complaint, ¶ 35). B. The Form 10-K Report. On March 31, 1995, NEI filed with the Securities and Exchange Commission (“SEC”), its Form 10-K for the year ending December 3Í, 1994. (Complaint, ¶ 36). In the Introductory section, NEI describes its current Japanese market and the potential market in the United States for its products. (Mar. 31,1995 Form 10-K, NEI Ex. A, p. 2). The background section indicates that, in addition to its main office in Michigan, NEI opened, between mid-1994 and early 1995, a small technical support office in Tokyo and sales offices in California, the United Kingdom, and New York, id. at pp. 2-3, and further indicates here that during this same time it established two subsidiaries, Network Express K.K. in Japan and Network Express Europe Ltd. Id. The Form 10-K Report includes a Risk Factors section which discusses the business risks that NEI faces. Here, NEI states the following: The Company’s business is subject to significant risks, including, but not necessarily limited to, the factors set forth below. Dependence on Single Customer. In 1992, 1993, and 1994, sales to Soliton Systems, K.K. (“Soliton”), the exclusive distributor of the Company’s products in Japan, accounted for approximately 54%, 79%, and 88%, respectively, of the Company’s net sales. The Company expects this sales concentration to continue at least through 1995. A majority of such sales are attributable to NE ISDN Router products. Under the Company’s agreement with Soliton (the “Soliton Agreement”), Soliton alone may distribute the Company’s products in Japan; however, Soliton may sell products of other companies, including those of the Company’s competitors ... Further, the Soliton Agreement expires in April 1997 and there can be no assurance that it will be renewed, or, if renewed, that its terms will be as favorable ... Any deemphasis of the Company’s products by Soliton, termination of the Soliton Agreement, modifications to terms less favorable to the Company, or any operational or financial failure of Soliton, could have a material adverse effect on the business, results of operations and financial condition of the Company ... The Company believes that Soliton is highly dependent on a limited number of customers. Any delays, changes in purchasing patterns, termination of programs or competition could have a material adverse affect on Soliton and, in turn, the Company. There can be no assurance that Soliton or its customers will continue to place orders with the Company. In addition, the sales cycles of the Company’s products are relatively long and often dependent upon factors such as the size and timing of Soliton’s customer’s projects. The Company’s planned product shipments for a single customer project can be a significant portion of a quarter’s revenue, and delays in the timing or the Company’s ability to meet delivery requirements could have a material adverse effect on the Company’s results of operations. In addition, decisions by customers to build inventory and sell from inventory could lead to reductions in demand, which could have a material adverse affect on the Company’s business, financial condition and results of operations. Fluctuations in Quarterly Operating Results. The Company expects that its quarterly operating results could fluctuate in the future as the result of several factors, including the Company’s ability to develop, introduce and ship new products, its mix of products sold, the mix of distribution channels employed, the success of its United States and European sales and marketing initiatives, ... [and] the gain or loss of significant customers ... The Company’s dependence on a single customer and its purchasing patterns in Japan also contributes to fluctuations in sales and unpredictability of future orders, and is expected to continue in the future ... [T]he Company has recently reduced prices to Soliton, its largest customer, and committed significant resources to developing a United States and European marketing capability. Consequently, there can be no assurance that the Company will be able to maintain profitability, particularly on a quarter to quarter basis. Limited History of Operations and Profitability. The Company was incorporated in March 1990 and began shipping products in June 1991. As of December 31, 1994, the Company had an accumulated deficit of $2,902,609. The Company has experienced higher levels of revenue on an annual basis and has been profitable in each of the last four fiscal quarters; however, there can be no assurance that revenue growth or profitability will continue. Technological Change, New Products and Market Acceptance. The data communications industry is characterized by rapid and significant technological change, the frequent introduction of new products and services using new technologies and short product life cycles ... The Company’s ability to anticipate and respond to changes in technology, industry standards and customer needs and to develop and introduce new (or enhance existing) products on a timely and cost-effective basis will be a significant factor in its competitive position and growth prospects____ There can be no assurance that the Company will be successful in developing, introducing or managing the transition to new or enhanced products or that any such products will be responsive to technological changes or will gain market acceptance in Japan or elsewhere. The Company’s business and operating results would be materially and adversely affected if the Company were to be unsuccessful, or to incur significant delays, in developing and introducing such new products or enhancements. In the past, the Company has experienced delays in product release and introduction, and there can be no assurance that such delays will not occur in the future ... Additionally, if technologies or standards supported by the services of telephone companies using the Company’s products, or the products themselves, become obsolete or fail to gain widespread commercial acceptance, the Company’s business may be adversely affected. Moreover, complex products such as those offered by the Company may contain undetected or unresolved software errors when they are first introduced or as new versions are released. There can be no assurance that, despite extensive testing by the Company, software errors will not be found in new products or upgrades after commencement of commercial shipments, resulting in delay or loss of market acceptance. Future delays in the introduction or shipment of new or enhanced products, the inability of such products to gain market acceptance or problems associated with new product transitions could adversely affect the Company’s operating results. ***,*** International Operations: Historical Reliance on Sales in Japan. International sales accounted for approximately 79%, 79%, and 88% of the Company’s net sales in 1992,1993, and 1994, respectively. Substantially all of these net sales were in Japan. The Company expects this sales concentration to continue at least throughout 1995. Although the Company’s near-term business strategy involves a commitment to developing the market in the United States, the long-term business strategy involves not only a continued focus on the market in Japan, but also a concerted effort in developing the market in Europe. ****** Limited Sales and Distribution in the United States and Europe. The Company’s United States distribution arrangements have to date been relatively limited and largely reliant on the sale of products to, and through, telephone companies. In the fourth quarter of 1994, the Company hired a new Vice President, Sales and Marketing, who has, in turn, increased the United States sales and marketing staff from eight to 14 persons. There can be no assurance that the Company’s efforts to increase United States sales will be successful or that increased costs expected in 1995 as a result of this initiative will not adversely affect the Company’s results of operations if revenues in the United States are not sufficient to meet the additional costs. In Europe, the Company has a nonexclusive distributor agreement with Telóme Gmbh to distribute the Company’s products in Germany and has recently opened an office in the United Kingdom to serve as a sales office for Europe. The foreign distribution arrangements so-far established by the Company are not guaranteed to continue or expand, and the Company’s success will depend upon its ability to identify suitable distributors in other markets, to negotiate satisfactory arrangements with them, and to maintain those arrangements. Volatility of Stock Price. The trading price of the Common stock has been and could be subject to wide fluctuations in response to quarterly variations in the Company’s operating, results, shortfalls in such operating results from levels forecast by securities analysts, announcements of technological innovations or new products by the Company or its competitors and other events or factors.... (Mar. 31, 1995 Form 10-K, NEI Ex. A, pp. 3-9) (emphasis in the original). The Form 10-K Report also describes NEI’s various products, including the NEL-ink-1000: The Company announced the introduction of the NELinkr-1000 in March 1995. Resulting from the Company’s product strategy, the NELink-1000 is an internetworking product designed for the small central site or remote location. It interoperates with a wide range of ISDN remote access products and Switched 56 LAN access devices, including terminal adapters, workstations, bridges and routers. The benefits of the NELink-1000 include performance ... reliability ... manageability, security, flexibility ... and economy. Several applications of the NELinlcr-1000 include telecommuting, Internet access, remote office connectivity, multimedia, remote X/terminals and video conferencing. The NELinkr-1000 utilizes a different platform than the Company’s larger products, and is the first product offered by the Company that is designed solely as a telecommunications device. Its physical characteristics were chosen to facilitate placement on a desktop or shelf in recognition that its targeted installation is at smaller remote sites, including remote workstations utilized by individual telecommuters .... (Mar. 31, 1995 Form 10-K, NEI Ex. A, p. 11). With respect to sales and marketing, the Form 10-K Report states that: The Company’s sales and marketing efforts in Japan, its largest market, are conducted through Soliton, the Company’s exclusive Japanese distributor. In the fourth quarter of 1994, the Company expanded its United States sales force from seven to 14 persons. The Company maintains a sales office in the United Kingdom which is responsible for European sales, and has entered into an agreement for the distribution of its products in Germany. Thus far, sales in the United States and Europe have not been significant to the Company’s results of operations. Japan. The Company believes it is the leading supplier of ISDN internetworking solutions in Japan. The Company sold its first routers there in 1992 and the market has expanded rapidly since that time. The Company’s marketing partner and exclusive distributor, Soliton, has developed customers and has installed more than 2,500 of the Company’s systems across several industries, including manufacturing, telecommunications, retail banking and engineering ... In 199k, the Company, through Soliton, began to work on larger network applications that will use the NE ISDN InterHub products to provide access by telephone companies and banks to large numbers of remote locations using ISDN. Competitors ... [are] also expanding their product offerings in this area. See “Risk Factors— Dependence on Single Customer.” United States. In the United States, the Company has developed customers in several industries and, with the market for ISDN steadily growing through the deployment of the network infrastructure, the Company expects this trend to continue. These customers include the federal government and companies involved in semiconductors, research and development, software, financial services, manufacturing, computer, education, realty, high tech, industrial communications, automotive and publishing. The Company’s products are used in many applications, including telecommuting, access to the Internet, graphics/pre-press production and videoconferencing. Due to its past focus on the Japanese market and in part to the relatively recent emergence of ISDN connectivity in the United States, the Company’s United States distribution arrangements have been relatively limited, and substantially reliant upon selling products to and through telephone companies and others. The Company’s United States sales strategy is to focus on enhancing relationships with telecommunications earners, value-added resellers and potential original equipment manufacturers, while continuing and expanding upon existing relationships with large government users of internet-working and Fortune 100 corporations. Europe. The Company’s European sales strategy is to continue the process of homologation, or certification of its products, in the European countries. In September 1994, the company established a sales office in the United Kingdom which will assist in the process of homologation. The Company plans to use distributors in connection with the sale of its products in Europe and, to that end, the Company appointed its first European distributor, Telonie, which, pursuant to an agreement dated August 1, 1993, has been granted marketing rights in Germany and has been appointed a master software distributor with a right to sub-license. Id. at pp. 12-13. C. The 1994 Annual Report to Shareholders. In early April 1995, NEI distributed its 1994 Annual Report to Shareholders. (Complaint, ¶37). The Table of Contents page declares that: “NEI’s initial focus was Japan, where ISDN is widely available. As the Regional Bell Operating Companies (RBOCs) deploy ISDN more extensively in the U.S., NEI is expanding domestic marketing efforts and introducing new products.” (NEI’s 1994 Annual Report to Shareholders, Furman Selz and Unterberg Harris’ Ex. I). The Annual Report included a letter to shareholders in which NEI’s President and CEO Richard Eidswiek stated: I am very proud to report on the achievements of Network Express in the past year. The Company made excellent progress in all major areas of the business. Financial results were excellent. Sales rose 176 percent to $11.1 million from $4 million in 1993. Net income was $466,000, or $.07 per share, compared with a net loss of $900,000, or $.21 per share, a year ago. Sales to customers in Japan made up 88 percent of total revenue in 1994. ****** In Japan, we have a close working relationship with Soliton, our sole distributor and partner in that market. We concentrated on the Japanese market early in the growth of our business since ISDN was widely available from the Japanese telephone company when we began selling products in 1992. Now, ISDN is becoming more fully deployed in the U.S. and European markets through the Regional Bell Operating Companies (RBOCs) and European telephone companies. We have positioned our business to take advantage of this proven technology. Our marketing and sales strategies to attain results in the U.S. market are outlined in this report. ****** Our products’ performance and capabilities have been proven in the demanding, quality-conscious and competitive Japanese market since 1992. We expect continued growth in the Japanese market as we begin to open markets in the U.S. and Europe as ISDN technology becomes more widely available. Telephone companies are deploying ISDN in many areas of the U.S. and Europe and our strategy is to continue to work closely with them, to sell directly to serve customers and to extend the sales effort in our distributor network to give us broader coverage of the market. The people at Network Express appreciate the confidence of our investors and customers. This is an exciting time for your Company and I look forward to reporting to you on our progress throughout the year. (NEI 1994 Annual Report Furman Selz and Unterberg Harris’ Ex. I, pp. 2-3). The 1994 Annual Report also provides some background regarding the deployment of ISDN technology. Id. at p. 4. The next section describes NEI’s geographic markets: Japan Network express is a leader in ISDN internetworking solutions in Japan. NEI sold its first routers there in 1992 and the market has expanded rapidly since that time. In 1994, 88 percent of revenue was generated by NEI products sold in Japan. ‡ ‡ ‡ ‡ ‡ ‡ NEI’s Japanese marketing partner and distributor, Soliton Systems K.K., has developed a customer base and has more than 2,500 systems installed at customer sites across several industries — manufacturing, telecommunications, retail, banking and engineering. Customers are using NEI products in mission-critical ISDN networks. Applications range from client/server networks for accounting and administration systems to engineering networks that connect remote laboratories. Hundreds of NEI systems are linked in some networks. Other systems use a central-site solution to connect networks. In 1994, NEI began working with Soliton on larger network applications that will use the InterHub products to provide access to hundreds of remote locations using ISDN. North America With the U.S. market for ISDN growing steadily through deployment of the network infrastructure, NEI has developed customers in several industries. They include federal government, semiconductor, research, software, financial services, manufacturing, computer, education, realty, engineering, industrial communications, automotive and publishing. H* Hí Sales to U.S. customers take place through different marketing channels. NEI’s direct sales force works with telephone companies and other target prospects. Sales people also develop new accounts for master value-added resellers and distributors who then work directly with customers. The sales and marketing team is expanding rapidly to meet the growing demand in the U.S. market. Europe ISDN is widely available through telephone companies in several European nations, including Germany, France and England. To take advantage of this established infrastructure, the Company began European operations by establishing a London office in 1994. Sales and support people are developing new customers and organizing a European distributor network. NEI is targeting the largest companies in Europe and is also developing strategic relationships with phone companies and certain other customers. Applications include InterHubs for Internet access and work-at-home applications as well as Router networks. (1994 Annual Report, Furman Selz and Unterberg Harris’ Ex. I, pp. 5-6). The Annual Report also highlights NEI’s products: Network Express is taking advantage of the growth that is occurring in the worldwide ISDN market. The Company expects to benefit from the emerging wave of internetworking in which LAN-to-LAN communications are becoming important to many computer users. * * % * * * The Company has a range of products, known as the NE series, that fits the needs of both large and small networks. The NE ISDN Router and the NE ISDN InterHub are software products that run across a group of hardware platforms called the NE 2000-11, NE 4000 and NE 5000. The NELink-1000, scheduled to be released this Spring, is a fully integrated internetworking device. It is designed for central sites or remote offices getting started with ISDN internetworking. The NELink-1000 provides economical inter-networking access for the remote sites. Id. at pp. 6-7. With respect to manufacturing, the Annual Report states that: The Company’s strategy is to design products based on market needs and then to use well-qualified suppliers to assemble, bum in and test all components and sub-assemblies. Two of the Company’s key suppliers for the outsourcing are Pioneer-Standard Electronics, Inc., of Cleveland, OH and Adco Circuits of Rochester Hills, MI. Products are then tested for quality standards, assembled and shipped under Network Express control. The policy of integrating products rather than manufacturing them allows more focus on customer needs by delivering high quality products without investing in capital intensive manufacturing equipment. Id. at p. 7. D. The Prospectus. Pursuant to its May 18, 1995 Secondary Offering, NEI sold 2.2 million shares and Eidswick, Hartmann, Carson, Kinnear, Sullivan, and Swanson sold, in total, 600,000 shares of their own. (Complaint, ¶ 42). The price to the public for these shares was $13.25 per share. (Id.). Incident to the Secondary Offering, NEI and Furman Selz and Unterberg Harris filed with the SEC an April 23, 1995 preliminary prospectus and a May 18, 1995 final prospectus (collectively referred to as the “Prospectus” as they contain the same statements). (Complaint, ¶¶40, 42). On the front page, the Prospectus states in bold print that “The Common Stock offered hereby involves a high degree of risk. See ‘Risk Factors.’ ” (May 18, 1995 Prospectus, NEI Ex. B, p. 1). Thereafter, a summary of the Prospectus is provided: The following summary is qualified in its entirety by the more detailed information and the consolidated financial statements and notes thereto found elsewhere in this Prospectus ... Prospective investors are advised to devote particular attention to the text under “Risk Factors. ” * * * * * * The Company offers two core product families, which together are known as the NE Series: (a) the NE ISDN Router ... and (b) the NE ISDN InterHub ... * * * :f; * % The Company’s core software technology is embodied in an architecture to address the special needs of dial-up ISDN internet-working involving transparent bandwidth management, security, interoperability and call management. The principal market for the Company’s products to date has been large corporations in Japan, where ISDN has been fully deployed for some time. A principal component of the Company’s business strategy, however, is to expand sales in the United States, where the deployment of ISDN has been relatively slow, but more recently has begun to increase. The Company believes that its experience in meeting the needs of large corporations in Japan gives it a competitive advantage as it is able to offer its customers products of proven functionality and performance. As of March 31, 1995, the Company had sold over 3,600 units, 3,300 of which were sold in Japan. Id. at p. 3 (emphasis in original). The Prospectus then lists Risk Factors which it advises “should be considered carefully in addition to the other information contained in this Prospectus before purchasing the Common Stock offered hereby.” Id. at p. 5 (emphasis in original). These Risk Factors, which are very similar to those that NEI identified in its March 31, 1995 Form 10-K, include: Dependence on Single Customer. In 1992, 1993, and 1994, sales to Soliton Systems, K.K. (“Soliton”), the exclusive distributor of the Company’s products in Japan, accounted for approximately 54%, 79%, and 88%, respectively, of the Company’s net sales (and approximately 93% of net sales in the first quarter of 1995). A majority of such net sales are attributable to NE ISDN Router products. The Company expects this sales concentration to continue at least throughout 1995. These products accounted for 76% and 78% of net sales in 1993 and 1994, respectively, and are expected to decrease in future periods as a percentage of the Company’s net sales. Under the Company’s agreement with Soliton (the “Soliton Agreement”), Soliton alone may distribute the Company’s products in Japan; however, Soliton may sell products of other companies, including those of the Company’s competitors ... Further, the Soliton Agreement, as amended effective April 1, 1995, expires in April 1997 and there can be no assurance that it will be renewed, or, if renewed, that its terms will be as favorable ... Any deemphasis of the Company’s products by Soliton, termination of the Soliton Agreement, modifications to terms less favorable to the Company, or any operational .or financial failure of Soliton, could have a material adverse effect on the business, results of operations and financial condition of the Company. Soliton, itself, is the manufacturer of certain competing products directed at workstation ISDN access. See “Business — Sales and Marketing.” The Company believes that Soliton is highly dependent on a limited number of customers, including one customer, Nippon Telephone & Telegraph (“NTT”), which accounted for over 50% of Soliton’s revenue in 1994. Any delays, changes in purchasing patterns, termination of programs or competition could have a material adverse affect on Soliton and, in turn, the Company. There can be no assurance that Soliton or its customers will continue to place orders with the Company. In addition, the sales cycles of the Company’s products are relatively long and often dependent upon factors such as the size and timing of Soliton’s customer’s projects. The Company’s planned product shipments for a single customer project can be a significant portion of a quarter’s revenue, and delays in the timing or the Company’s ability to meet delivery requirements could have a material adverse effect on the Company’s results of operations. In addition, decisions by customers to build inventory and sell from inventory could lead to reductions in demand, which could have a material adverse affect on the Company’s business, financial condition and results of operations. Limited History of Operations and Profitability. The Company was incorporated in March 1990 and began shipping products in June 1991. As of December 31, 1994, the Company had an accumulated deficit of $2,909,609. The Company has experienced higher levels of revenue on an annual basis and has been profitable in each of the last four fiscal quarters; however, there can be no assurance that revenue growth or profitability will continue. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition.” Technological Change, New Products and Market Acceptance. The data communications industry is characterized by rapid and significant technological change, the frequent introduction of new products and services using new technologies and short product life cycles ... The Company’s ability to anticipate and respond to changes in technology, industry standards and customer needs and to develop and introduce new (or enhance existing) products on a timely and cost-effective basis will be a significant factor in its competitive position and growth prospects____ There can be no assurance that the Company will be successful in identifying, managing, developing, manufacturing or marketing product enhancements or new products that respond to technological change or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction or marketing of such products, or that its new products and product enhancements will adequately meet the requirements of the marketplace and achieve market acceptance in Japan or elsewhere. The Company’s business and operating results would be materially and adversely affected if the Company were to be unsuccessful, or to incur significant delays, in developing and introducing such new products or enhancements. The Company introduced the NELink-1000 in March 1995 to meet perceived market demand in Japan for a product designed solely as a telecommunications device. There can be no assurance that the NELink-1000 will adequately meet the requirements of the marketplace and achieve market acceptance in Japan or elsewhere. In the past, the Company has experienced delays in product release and introduction, and there can be no assurance that such delays will not occur in the future ... Additionally, if technologies or standards supported by the services of telephone companies using the Company’s products, or the products themselves, become obsolete or fail to gain widespread commercial acceptance, the Company’s business may be adversely affected. Moreover, complex products such as those offered by the Company may contain undetected or unresolved software errors when they are first introduced or as new versions are released. There can be no assurance that, despite extensive testing by the Company, software errors will not be found in new products or upgrades after commencement of commercial shipments, resulting in delay or loss of market acceptance. Future delays in the introduction or shipment of new or enhanced products, the inability of such products to gain market acceptance or problems associated with new product transitions could adversely affect the Company’s operating results. Need to Expand Product Offering____ A majority of the Company’s net sales are attributable to NE ISDN Router products sold in Japan. These products accounted for 76% and 78% of the net sales in 1993 and 1994, respectively, and are expected to decrease in future periods as a percentage of the Company’s net sales. Because of differences in LAN configurations between the United States and Japan and market preferences for interoperable products in the United States, the Company believes that sales in the United States, should such market develop, will be largely dependent upon NE ISDN InterHub products. Such products have not to date accounted for a significant percentage of sales in Japan or elsewhere. The Company believes that its product offerings must be increased to offer products for the large end-user segment of the market which includes scaling up product connectivity and functionality and scaling down to accommodate single user remote sites, such as those found in organizations where telecommuting is important____ There can be no assurance that the Company’s scale-up/scale-down plans will be successful, or that the efforts currently underway or planned will be accomplished at reasonable cost. The failure to successfully implement this strategy could have a material adverse effect on the Company’s ability to develop meaningful United States sales and could adversely affect the Company’s business, operations and financial condition. See “Business — Business Strategy” and “Business — Sales and Marketing.” Fluctuations in Quarterly Operating Results. The Company expects that its quarterly operating results will fluctuate in the future as the result of several factors, including the Company’s ability to develop, introduce and ship new products, ... the success of its United States and European sales and marketing initiatives, ... market acceptance of new or enhanced versions of the Company’s products, ... [and] the gain or loss of significant customers ... The Company’s dependence on a single customer in Japan and such customer’s purchasing also contributes to fluctuations in sales and unpredictability of future orders, and is expected to continue in the future---- All of the foregoing factors are difficult for the Company to forecast, and these and other factors can materially and adversely affect the Company’s business and operating results for one quarter or for a series of quarters. The Company receives a limited number of large purchase orders from its major customer, which in turn, is reliant on purchase orders from its major customers____ If sales are below expectations in any given quarter, the adverse impact of the shortfall on the Company’s operating results may be magnified by the Company’s inability to adjust spending to compensate for the shortfall. The Company may also reduce prices or increase spending in response to competition or to pursue new market opportunities. In this regard, the Company has recently reduced prices to Soliton, its largest customer, and committed significant resources to developing a United States and European marketing capability. Consequently, there can be no assurance that the Company will be able to maintain profitability, particularly on a quarter to quarter basis. ****** Limited Sales and Distribution in the United States and Europe. The Company’s United States distribution arrangements have to date been relatively limited and largely reliant on the sale of products to, and through, telephone companies. In the fourth quarter of 1994, the Company hired a new Vice President, Sales and Marketing, who has, in turn, increased the United States sales and marketing staff from eight to 14 persons. There can be no assurance that the Company’s efforts to increase United States sales will be successful or that increase costs expected in 1995 as a result of this initiative will not adversely affect the Company’s results of operations if revenues in the United States are not sufficient to meet the additional costs. In Europe, the Company has a nonexclusive distributor agreement with Telonio Gmbh to distribute the Company’s products in Germany and has recently opened an office in the United Kingdom to serve as a sales office for Europe. The foreign distribution arrangements so-far established by the Company are not guaranteed to continue or expand, and the Company’s success will depend upon its ability to identify suitable distributors in other markets, to negotiate satisfactory arrangements with them, and to maintain those arrangements. ****** International Operations; Historical Reliance on Sales in Japan. International sales accounted for approximately 79%, 79%, and 88% of the Company’s net sales in 1992, 1993, and 1994, respectively (and approximately 93% of net sales in the first quarter of 1995). Substantially all of these net sales were in Japan. The Company expects this sales concentration to continue at least through 1995. Although the Company’s near-term business strategy involves a commitment to developing the market in the United States, the long-term business strategy involves not only a continued focus on the market in Japan, but also a concerted effort in developing the market in Europe. ****** Shares Eligible for Future Sale. Sales of substantial amounts of Common Stock in the public market after this offering could adversely affect prevailing market prices for the Common Stock ... Taking into account restrictions imposed by the Securities Act of 1933 (the “Securities Act”), rules and regulations promulgated thereunder and lock-up agreements between certain shareholders of the Company and the representatives of the Underwriters [, Furman Selz and Unterberg Harris,] the number of shares that will be available for sale in the open market ... will be as follows: (i) 7,765,412 shares will be eligible for immediate sale; and (ii) approximately 1,057,020 shares will be eligible for sale beginning 120 days after the date of this Prospectus____ ****** Volatility of Stock Price. The trading price of the Common stock has been and could be subject to wide fluctuations in response to quarterly variations' in the Company’s operating results, shortfalls in such operating results from levels forecast by securities analysts, announcements of technological innovations or new products by the Company or its competitors and other events or factors.... (May 18,1995 Prospectus, NEI Ex. B, pp. 5-11). The Prospectus contains a separate section which discusses NEI’s net sales: ... Net sales increased 187% from $1.4 million in 1992 to $4.0 million in 1993 and increased 176% to $11.1 million in 1994. Sales of the Company’s products in Japan represented $1.1 million, or 79% of net sales in 1992, $3.2 million, or 79% of net sales in 1993, and $9.8 million, or 88% of net sales in 1994, with the balance in each year derived primarily from the United States ... ****** Sales in Japan, which since September 1992 have resulted solely from Soliton purchase orders, have increased in every quarter during the past two years. For the fourth quarter of 1994, sales to Japan were approximately $3.5 million, which represented approximately 35% of total Japanese sales for the year____ A majority of net sales ... are attributable to NE ISDN Router products. These products accounted for 76% and 78% of net sales in 1993 and 1994, respectively, and are expected to decrease in future periods as a percentage of the Company’s net sales. ****** ... In the United States, sales comprised 21%, 20% and 12% of net sales in 1992, 1993 and 1994, respectively. Sales in Europe have not been significant. ****** Quarters Ended March 31, 1994 and 1995 ... Net sales increased 138% from $1.9 million in the quarter ended March 31, 1994 to $4.5 million in the quarter ended March 31, 1995. Sales of the Company’s products in Japan represented $1.7 million or 89% of net sales in the quarter ended March 31, 1994, and $4.2 million or 93% of net sales in the quarter ended March 31, 1995, with the balance in each quarter being derived primarily from the United States. The overall sales increase resulted from customer acceptance and continued deployment of the Company’s products, new software releases and Soliton’s success in penetrating the Japanese market. Id. at pp. 15-16. With respect to NEI’s business strategy, the Prospectus states that: Maintain and Leverage Strong Position in Japan ... The Company believes that its early focus on Japan has given it the opportunity to demonstrate the functionality of its products in a mature market for ISDN communications which will enhance its position in selling its products as proven performers in other markets, including the United States and Europe ... A majority of the Company’s net sales are attributable to NE ISDN Router products sold in Japan. These products accounted for 76% and 78% of net sales in 1993 and 1994, respectively, and are expected to decrease in future periods as a percentage of the Company’s net sales. Because of differences in LAN configurations between the United States and Japan and market preferences for interoperable products in the United States, the Company believes that sales in the United States, should such market develop, will be largely dependent upon NE ISDN InterHub products ... Increase United States and European Penetration Since its inception, the Company’s sales efforts have been primarily focused on Japan and, as a result, sales in the United States and Europe have not been significant, accounting for approximately 12% and less than 1%, respectively, of the Company’s net sales in 1994. A key component of the Company’s business strategy is to develop these markets. Efforts ... will be directed to securing relationships with the [Regional Bell Operating Companies], strategic value-added resellers of computer products to businesses, large end-users and potential original equipment manufacturers and to emphasizing the scalability of the Company’s products for purposes of addressing the perceived needs of the United States market____ Id. at p. 24. Regarding the NELink-1000, the Prospectus states that: The Company introduced the NELinh1000 in March 1995. Resulting from the Company’s scalable product strategy, the NELinkr-1000 is an internetworking product designed for the small central site or remote location. It interoperates with a wide range of ISDN remote access products and Switched 56 LAN access devices, including terminal adapters, workstations and routers ... Several potential applica tions of the NELinkr-1000 include telecommuting, Internet access, remote office connectivity, multimedia, remote X/terminals and videoconferencing. The NELinkr-1000 utilizes a different hardware platform than the Company’s larger products, and is the first product offered by the Company that is designed solely as a telecommunication device. Its physical characteristics were chosen to facilitate placement on a desktop or shelf in recognition that its targeted installation is at smaller sites, including remote workstations utilized by individual telecommuters. Id. at p. 28. The Sales and Marketing section of the Prospectus describes the past, present, and future of NEI’s endeavors in Japan, the United States, and Europe: Since September 1992, the Company’s sales and marketing efforts in Japan, its largest market, have been conducted through Soliton, the Company’s exclusive Japanese distributor. In December 1994, the Company hired a new Vice President, Sales and Marketing, who has, in turn, increased the United States sales and marketing staff from eight to 20 persons, to begin the Company’s first concentrated effort on developing sales in the United States. The Company maintains a sales office in the United Kingdom employing two sales persons which is responsible for European sales, and has entered into an agreement for the distribution of its products in Germany. Thus, far sales in the United States and Europe have not been significant to the Company’s results of operations, accounting for approximately 12% and less than 1%, respectively, of the Company’s net sales in 1994. Japan. The Company believes it is the leading supplier of ISDN internetworking solutions in Japan. The Company sold its first routers there in 1992 and the market has expanded rapidly since that time. The Company’s marketing partner and exclusive distributor, Soliton, has developed customers and has installed more than 3,000 of the Company’s units across several industries, including manufacturing, telecommunications, retail banking and engineering ... In 1992, the Company entered into the Soliton Agreement, pursuant to which Soliton has been granted the exclusive right to sell the Company’s products in Japan. The Soliton Agreement, as amended effective April 1, 1995, expires in April 1997, but is automatically renewed for one-year periods if not terminated by either party by notice delivered at least three months prior to the expiration of the current term or any extension thereof ... Soliton ... currently sells products that may be competitive with the Company’s products ... In addition Soliton itself is the manufacturer of certain competing products ... Sales in Japan normally rise upon Soliton’s receipt of a purchase commitment from its own distributor or customer. These sales are recorded upon shipment from the Company or drop shipment from the Japanese assembler, with payment to the Company due 45 days after the shipping date. As of March 31, 1995, the Company had sold and delivered approximately 3,300 units in Japan ... The Company believes that Soliton is highly dependent on a limited number of customers, including one customer, NTT, which accounted for over 50% of Soliton’s revenue in 1994. Any delays, chánges in purchasing patterns, termination of programs or competition could have a material adverse affect on Soliton and, in turn, the Company. There can be no assurance that Soliton or its customers will continue to place orders with the Company. In addition, the sales cycles of the Company’s products are relatively long and often dependent upon factors such as the size and timing of Soliton’s customer’s projects. The Company’s planned product shipments for a single customer project can be a significant portion of a quarter’s revenue, and delays in the timing or the Company’s ability to meet delivery requirements could have a material adverse effect on the Company’s results of operations. In addition, decisions by customers to build inventory and sell from inventory could lead to reductions in demand, which could have a material adverse affect on the Company’s business, financial condition and results of operations. United States. In the United States, the Company has developed customers in several industries and, with the market for ISDN steadily growing through the deployment- of the network infrastructure, the Company expects this trend to continue. These customers include the federal government and companies involved in semiconductors, research and development, software, financial services, manufacturing, computer, education, realty, high tech, industrial communications, automotive and publishing. The Company’s products are used in many applications, including telecommuting, access to the Internet, graphics/pre-press production and videoconferencing. Due to its past focus on the Japanese market and in part to the relatively recent emergence of ISDN connectivity in the United States, the Company’s United States distribution arrangements have been relatively limited, and substantially reliant upon selling products to and through telephone companies and others. In addition, the cost of dedicated leased lines in the United States is low and competitive with that of dial-up services, and this is expected to inhibit the demand for such services and, hence, for the Company’s products relative -to the international market. The Company’s United States sales strategy is to focus on enhancing relationships with telecommunications carriers, value-added resellers and potential original equipment manufacturers, while continuing and expanding upon existing relationships with large government users of internetworking and Fortune 1000 corporations. To that end, the Company recently entered into an agreement with Intellicom Solutions, Inc., a subsidiary of Intelligent Electronics, pursuant to which Intellieom has agreed to distribute the Company’s products. There can be no assurance that this agreement will significantly affect realization of the Company’s United States sales and marketing strategy- Europe. The Company’s European sales strategy is to continue the process of homologation, or certification of its products, in the European countries. In September 1994, the company established a sales office in the United Kingdom which will assist in the process of homologation. The Company plans to use distributors in connection with the sale of its products in Europe and, to that end, the Company appointed its first European distributor, Telonie, which, pursuant to an agreement dated August 1, 1993, has been granted marketing rights in Germany and has been appointed a master software distributor with a right to sub-license. (May 18, 1995 Prospectus, NEI Ex. B, pp. 29-31). Finally, in the “Technological Change, New Products and Market Acceptance” Section, the Prospectus discusses the NE Link-1000: New product introductions could contribute to quarterly fluctuations in operating results as orders for new products commence and orders for existing products decline. In addition, the Company has shipped and may continue to ship products with a commitment to upgrade such products. There can be no. assurance that the Company will be successful in identifying, managing, developing, manufacturing or marketing product enhancements or new products that respond to technological change or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction or marketing of such products, or that its new products and product enhancements will adequately meet the requirements of the marketplace and achieve market acceptance in Japan or elsewhere. The Company’s business and operating results would be materially and adversely affected if the Company were to be unsuccessful, or to incur significant delays, in developing and introducing such new products or enhancements---- There can be no assurance that the NELink-1000 will adequately meet the requirements of the marketplace and achieve market acceptance in Japan or elsewhere. In the past, the Company has experienced delays in product release and introduction, and there can be no assurance that such delays will not occur in the future.... Additionally, if technologies or standards supported by the services of telephone companies using the Company’s products, or the products themselves, become obsolete or fail to gain widespread commercial acceptance, the Company’s business may be adversely affected. Moreover, complex products such as those offered by the Company may contain undetected or unresolved software errors when they are first introduced or as new versions are released. There can be no assurance that, despite extensive testing by the Company, software errors will not be found in new products or upgrades after commencement of commercial shipments, resulting in delay or loss of market acceptance. Future delays in the introduction or shipment of new or enhanced products, the inability of such products to gain market acceptance or problems associated with new product transitions could adversely affect the Company’s operating results. Id. at pp. 34-35. E. The “Roadshow.” Between May 1, 1995 and May 15, 1995, NEI, Eidswick, Hartmann, Furman Selz and Unterberg Harris conducted a “Roadshow” in major U.S. cities (including New York, Chicago, Detroit, and San Francisco). (Complaint, ¶41). During the Roadshow, these Defendants met with and made presentations to existing NEI shareholders, institutional investors, securities analysts and potential purchasers of NEI stock. (Id.). During these meetings and presentations, Eidswick and Hartmann stated that: □ NEI’s business in Japan was strong and, based on that strength, NEI expected its revenues from Japan to remain strong and increase over the next few years. □ NEI’s business in the United States was succeeding, it was expanding its sales and marketing staff to meet the growth in the United States, and NEI expected its United States revenues to increase greatly in 1995 and 1996 to $3 million and $11 million, respectively. □ NEI’s business in Europe was succeeding and NEI expected its European revenues to expand greatly in 1996 to at least $2.5 million. □ NEI’s newest product, the NELink1000, was a terrific success, in part, because of its remote access capabilities. □ NEI expected strong sequential revenue and earnings growth throughout 1995 and 1996, with earnings per share reaching $.21>-$.26 and $.37 per share, respectively. (Complaint, ¶ 41). F. The Unterberg Harris June 1,1995 Research Report. On June 1, 1995, Unterberg Harris issued a Research Report on NEI which NEI reviewed and approved prior to its release and which NEI subsequently copied and distributed to the public. (Complaint, ¶ 43). Here, Unterberg Harris provided the following revenue analysis of NEI: EPS FY95E FY96E Q1 $0.05A $0.06E Q2 $0.05E $0.07E Q3 $0.06E $0.11E Q4 $0,07E $0.14E Year $0.24E $0.38E Unterberg Harris June 1, 1995 Report, Fur-man Selz and Unterberg Harris’ Ex. C, p. 5. In the Company Background section, Unterberg Harris states that: Through a strong relationship with Soliton Systems, a significant systems integrator in Japan, Network Express is a leading provider of ISDN product to the Japanese market and has been extremely successful in developing long-term relationships with many large Japanese companies and the telephone company — NTT. Soliton. is the Company’s exclusive distributor in Japan, and sold and serviced approximately $9.8 million of products in Japan in 1994, up from approximately $3.0 million in 1993. NTT, the country’s largest telephone company, and one of the largest companies in the world, is a strong believer in Network Express’ quality, service and technology and we believe will continue to be a strong buyer of Network Express products. While Japan has been the Company’s primary focus to date (between 80% and 90% of total sales), with increased interest by U.S. and European telephone companies to deploy ISDN for both corporate and home use, and with the changing needs of remote users who now require high-speed data transfer and Internet access, Network Express is poised to take advantage of the rapidly growing ISDN market both in the U.S. and Europe. Although we expect Japanese ISDN needs to double in the next three years — and Network Express/Soliton should manage to dominate this growth — we forecast that successful penetration of the U.S. and European markets will cause Japanese sales as a percentage of total Company sales to decrease progressively in 1996 and beyond. Id. at p. 5. In the following section of the Report, Unterberg Harris describes the ISDN technology and what is necessary to deploy it: ISDN can only be used once a carrier installs the necessary technology in the central office and the appropriate equipment is bought by the user. NTT — the Japanese Telephone company — began installing ISDN extensively nearly 5 years ago. Today, most Japanese telephone lines can accommodate ISDN interfaces. Network Express was one of the companies selected by NTT to provide customer end equipment. The pace has been slower in the United States____ The Regional Bell Operating Companies (RBOCs) are responding. Today nearly 80% of U.S. telephone line can accommodate ISDN end-line equipment; 100% accommodation is not far off. Demand for ISDN equipment in the United States is poised for an explosion and Network Express is gearing up to penetrate this market opportunity. • Id. at pp. 6-7. The Market Growth section of the Report contains the following statements: United States — finally turning towards ISDN Most estimates indicate that the number of Basic Rate ISDN lines in the United States in 1994 was approximately 300,000. It is estimated that the growth in BRI lines in the United States will be approximately 70% this year. We are in the early stages of a market that only developed in the last two years as the phone companies began to offer the service widely. The U.S. market is expected