LIONEL Z. GLANCY #134180
TRACY L. THROWER #145782
MICHAEL GOLDBERG #188669
LAW OFFICES OF LIONEL Z. GLANCY
1801 Avenue of the Stars, Suite 311
Los Angeles, California 90067
Phone: (310) 201-9150
Fax: (310) 201-9160
Lead Counsel For Plaintiffs
ROBERT C. SUSSER
ROBERT C. SUSSER, P.C.
6 East 43rd Street, Suite 1900
New York, New York 10017-4609
Attorneys For Plaintiffs
[Additional Counsel Appear on Signature Page]
UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF CALIFORNIA
ROBERT REE, FRANK BIANCHI, MARK ) Civ. Action No.
BOUQUET, TIMOTHY CASTELL, AMY ) C99-0562 MMC
CHU, ELYSE COLEMAN, LISA )
CUSTODIO, ROBERT CUVA, MILES )
DAUB, DAVID DREWEK, DONALD ) Hon. Maxine M. Chesney
FOUGHT, ALLEN GERSTON, ALBERT )
JACKSON, DARYL JOHNSON, RICHARD )
KAIN, SAID KHATIB, CARL KIRCHER, ) AMENDED CLASS ACTION
LARRY KOLODEY, NICHOLAS LAURORA, ) COMPLAINT
JENNINE LINDBERG, PATRICIA ) [filed Jun. 25, 1999]
MALLOY, STUART MATT, TODD )
MATTHEWS, DAVID MILLER, KURT ) JURY TRIAL DEMANDED
MITCHELL, ROBERT MORRISON, MYRON )
OLSON, SHARON QUERCIOLI, MARTHA )
RABKIN, MARIO SCOMA, BEN )
STACKLER, JAMES STAUBER, MARTHA )
STOVALL, ANTHONY STRACHAN, FRANK )
STROCK, GENE TORBECK, THOMAS )
TRENKMANN, TED VALK, BARRY )
WEISMAN, BERNARD WIEST and )
DOUGLAS WRAY, )
)
Plaintiffs, )
)
v. )
)
WARREN E. PINCKERT, II and )
CHOLESTECH CORPORATION, )
)
Defendants. )
___________________________________)
Plaintiffs, by their attorneys, for their amended
complaint, allege the following upon personal knowledge as to
themselves and their own acts, and upon information and belief
based upon the investigation made by their attorneys as to all
other matters. The investigation includes interviews with
former employees, consultations with experts and others
familiar with the business of Cholestech Corporation
("Cholestech" or the "Company"), as well as the thorough review
and analysis of public statements, press releases and publicly-
filed documents of Cholestech, and the review of news articles,
and analysis of accounting rules and related literature.
SUMMARY OF THE ACTION
1. Plaintiffs bring this action as a class action on
behalf of all purchasers of the common stock of Cholestech
between June 28, 1996 and June 25, 1998, inclusive (the "Class
Period"), to recover damages caused by defendants' violations
of the federal securities laws.
2. Defendant Cholestech, in conjunction with its senior
management, fraudulently presented the appearance of thirteen
quarters of reported sequential revenue growth for purposes of
meeting analysts' expectations and effecting a proposed
secondary offering. Defendants succeeded in reporting such
growth by engaging in a variety of accounting schemes that
masked problems the Company was having with acceptance of its
flagship product, the LDX System.
3. During the Class Period, Cholestech materially
overstated its earnings, revenues, and prospects by, inter
alia:
a. Engaging in massive "channel stuffing" of
product to distributors, including extraordinary stocking
orders, which frequently included implicit or explicit rights
of return, while at the same time improperly recognizing
revenue with respect to these "deals;"
b. Resorting to questionable accounting
adjustments and inaccuracies including, but not limited to, the
way Cholestech accounted for obsolete, scrap, and off-site
inventory, which resulted in distorted inventory values being
reported on Cholestech's financial statements; and
c. Materially misrepresenting the "installed
base" of LDX Analyzers, thereby creating the illusion of
significantly greater market demand for the high-margin single-
use cassettes sold by Cholestech for use in conjunction with
the Analyzer.
4. Indeed, the extraordinary "deals" referred to above
represented a materials portion of Cholestech's revenue during
the Class Period, including approximately 25% of revenue for
the fourth quarter of 1998. As one former Cholestech employee
reveals, it was "company strategy" to shift inventory from
Cholestech's shelves to distributors' shelves to meet
unreasonable internal forecasts. Notably, a stunning 97% of
Analyzers sold during the fourth quarter of 1998 were sold on a
"deal" basis as demonstrated by internal corporate documents
provided to plaintiffs' counsel. Also during the Class Period,
Cholestech's former Chief Financial Officer, Richard Janney,
discovered defendants' accounting improprieties and refused to
sign the Company's Form 10-Q for June 30, 1996, and was
terminated by defendant Pinckert, who signed the 10-Q himself
as the Company's "Principal Financial and Accounting Officer."
Further, because the Company used information regarding the
product sent to distributors, without regard to whether that
product had sold or would sell through to end-users, repeated
public representations throughout the Class Period regarding
Cholestech's "installed base" of Analyzers were false and/or
misleading.
5. In addition to disseminating a number of false and
misleading statements throughout the Class Period designed to
support the illusion of market acceptance for the LDX Analyzer,
defendants also reported false and misleading financial
results, concealing the effects of their wrongful channel
stuffing activities and other financial improprieties. These
false and misleading financial statements were reported in
Cholestech's press releases reporting quarterly and year-end
results and on Forms 10-Q and 10-K, filed with the Securities
and Exchange Commission (the "SEC").
6. On June 25, 1998, the last day of the Class Period,
the Company shocked the market by announcing a severe
anticipated revenue shortfall for the first quarter of fiscal
1999. Upon the Company's final disclosure of the adverse facts
known or disregarded by defendants throughout the Class Period,
the market price of Cholestech's shares, which traded as high
as nearly $18 per share during the Class Period, collapsed to
$6 per share from $11.75 per share, damaging plaintiffs and the
Class.
JURISDICTION AND VENUE
7. This Court has jurisdiction of this litigation under
Section 27 of the Securities Exchange Act of 1934 (the
"Exchange Act"). The claims asserted herein arise under
Sections 10(b) and 20(a) of the Exchange Act (15 U.S.C.
Sections 78j(b) and 78t) and Rule 10b-5 promulgated thereunder
(17 C.F.R. Section 240.10b-5).
8. Venue is proper in this District pursuant to Section
27 of the Exchange Act and 28 U.S.C. Section 1391(b).
Defendants reside in this District and many of the acts giving
rise to the violations complained of herein occurred in this
District, including dissemination of false and misleading
public statements and financial information.
9. In connection with the conduct complained of herein,
defendants, directly or indirectly, used the means and
instrumentalities of interstate commerce, including the United
States mails, interstate wire and telephone facilities and the
facilities of the national securities markets.
PARTIES
10. Plaintiffs Robert Ree, Frank Bianchi, Mark Bouquet,
Timothy Castell, Amy Chu, Elyse Coleman, Lisa Custodio, Robert
Cuva, Miles Daub, David Drewek, Donald Fought, Allen Gerston,
Albert Jackson, Daryl Johnson, Richard Kain, Said Khatib, Carl
Kircher, Larry Kolodey, Nicholas Laurora, Jennine Lindberg,
Patricia Malloy, Stuart Matt, Todd Matthews, David Miller, Kurt
Mitchell, Robert Morrison, Myron Olson, Sharon Quercioli,
Martha Rabkin, Mario Scoma, Ben Stackler, James Stauber, Martha
Stovall, Anthony Strachan, Frank Strock, Gene Torbeck, Thomas
Trenkmann, Ted Valk, Barry Weisman, Bernard Wiest and Douglas
Wray purchased the common stock of Cholestech during the Class
Period, as set forth in the shareholder certificates previously
filed with this Court.
11. Robert Cuva, Donald Fought, Albert Jackson, Carl
Kircher, Patricia Malloy and Sharon Quercioli were appointed
lead plaintiffs pursuant to this Court's Order dated May 17,
1999.
12. Defendant Cholestech is a California corporation
located at 3347 Investment Boulevard, Hayward, California.
Cholestech, together with its subsidiaries, develops,
manufactures and markets the Cholestech LDX System, a
diagnostic analyzer with a selection of disposable test
cassettes which provide immediate feedback of lipid levels in
point-of-care settings.
13. As of June 25, 1998, Cholestech had approximately
11,468,207 shares outstanding. Cholestech's shares trade on the
NASDAQ National Market System under the symbol "CTEC." At all
times relevant to this amended complaint, Cholestech common
stock traded actively in a well developed and efficient market
as that term is construed under the federal securities laws.
14. Defendant Warren E. Pinckert, II ("Pinckert") is, and
at all relevant times was, President, Chief Executive Officer
and a director of Cholestech. As an officer, director and/or
controlling person of a publicly-held company whose common
stock is registered with the SEC under the Exchange Act and
traded on the NASDAQ, defendant Pinckert had a duty to promptly
disseminate accurate and truthful information with respect to
the Company's operations, finances, financial conditions, and
present and future business prospects, to correct any
previously issued statement from any source that had become
untrue, and to disclose any trends that would materially affect
earnings and the present and future operating results of
Cholestech, so that the market price of the Company's publicly
traded securities would be based upon truthful and accurate
information.
15. During the Class Period, defendant Pinckert was a
senior executive and director of Cholestech and was privy to
confidential and proprietary information concerning Cholestech,
its operations, finances, financial condition, products, and
present and future business prospects. Because of his
possession of such information, defendant Pinckert knew or
recklessly disregarded the fact that the adverse facts
specified herein had not been disclosed to and were being
concealed from the public. Because of his Board membership and
executive and managerial position with Cholestech, defendant
Pinckert had access to adverse material non-public information
about Cholestech's operations, finances, financial condition,
products, inventories and present and future business
prospects. He had such access via internal corporate
documents, conversations and connections with other corporate
officers and employees, attendance at management and Board of
Directors meetings and committees thereof, and via reports and
other information provided to them in connection therewith.
Because of his possession of such information, defendant
Pinckert knew or recklessly disregarded the fact that the
adverse facts specified herein had not been disclosed to and
were being concealed from the public.
16. Defendant Pinckert, because of his position of
control and authority as officer and director of the Company,
was able to and did control the contents of the various
quarterly reports, SEC filings, press releases and
presentations to securities analysts pertaining to the Company.
17. Defendant Pinckert was provided with copies of
Cholestech's management reports, press releases and SEC
filings. Armed with, and in control of such information,
Pinckert spoke to analysts and granted interviews to newspaper
reporters from, among others, Investors Business Daily and the
San Jose Mercury News. The analyst reports and newspaper
articles based on those interviews, as well as the Company's
other publicly-disseminated information are alleged herein to
have been materially misleading to the investing public.
Significantly, defendant Pinckert had the ability and
opportunity to either prevent their issuance in the first place
or to have caused them to be corrected shortly after their
issuance. As a result, defendant Pinckert was responsible for
the accuracy of the public reports and releases detailed herein
as "group published" information, and is therefore responsible
and liable for the representations contained therein.
18. Each of the defendants is liable as a direct
participant with respect to the wrongs complained of herein.
In addition, defendant Pinckert, by reason of his stock
ownership and his status as an officer and director of
Cholestech was a "controlling person" within the meaning of
Section 20 of the Exchange Act and had the power and influence
to cause Cholestech to engage in the unlawful conduct
complained of herein. Because of his position of control,
defendant Pinckert was able to and did, directly or indirectly,
control the conduct of the Cholestech's business, the
information contained in its filings with the SEC, and the
public statements about its business.
19. During the Class Period, defendants, individually and
in concert, directly and indirectly, engaged and participated
in a continuous course of conduct to misrepresent the results
of Cholestech's operations, and to conceal adverse material
information regarding the finances, financial condition, and
results of operations of Cholestech as specified herein.
Defendants employed devices, schemes, and artifices to defraud,
and engaged in acts, practices, and a course of conduct, as
herein alleged, in an effort to increase and maintain an
artificially high market price for Cholestech common stock.
These activities included the formulating, making and/or
participating in the making of untrue statements of material
facts, and the omission to state material facts necessary in
order to make the statements made, in light of the
circumstances under which they were made, not misleading. Such
activities operated as a fraud or deceit upon plaintiffs and
the Class.
STATEMENTS IN ANALYST REPORTS
20. Cholestech and Pinckert are also responsible and
liable for materially false and misleading representations made
in the various analyst reports disseminated throughout the
Class Period, some of which are described herein, because those
statements were either 1) directly attributed to them; or 2)
adopted or ratified by them or their employees, including
Cholestech's Chief Financial Officer, Andrea Tiller.
21. At all times relevant to this action, Cholestech
and/or Pinckert directly met or communicated with analysts and
provided detailed and direct guidance to them regarding the
Company's business condition and future prospects. In
addition, the Company and/or Pinckert expressed comfort with
the estimates contained in those analyst reports. Defendants
reaffirmed the expectations stated by those analysts, thus
entangling themselves in the contents of the recommendations,
opinions, estimates and reports.
CLASS ACTION ALLEGATIONS
22. Plaintiffs bring this action as a class action
pursuant to Rules 23(a) and (b)(3) of the Federal Rules of
Civil Procedure on behalf of all persons who purchased
Cholestech common stock during the Class Period and were
damaged thereby. Excluded from the Class are defendants
herein; members of defendant Pinckert's immediate family; the
directors and officers of Cholestech; any corporation, firm,
partnership, trust or other person affiliated with any of the
foregoing; and the legal representatives, agents, heirs,
successors-in-interest or assigns of any excluded person.
23. The Class is so numerous that joinder of all members
is impracticable. As of June 25, 1998, Cholestech had
approximately 11,468,207 shares outstanding and such shares
were actively traded on the NASDAQ National Market System.
While the exact number of Class members is unknown to
plaintiffs at this time, and can only be ascertained through
appropriate discovery, plaintiffs believe that Class members
number in the thousands.
24. Plaintiffs' claims are typical of the claims of the
Class and plaintiffs and all members of the Class sustained
damages arising out of defendants' wrongful conduct in
violation of the federal laws complained of herein.
25. Plaintiffs will fairly and adequately protect the
interests of the Class and have chosen counsel experienced in
class and securities litigation.
26. Common questions of law and fact exist as to all
members of the Class and predominate over any questions
affecting solely individual members of the Class. These
questions include, but are not limited to, the following:
(a) Whether the federal securities laws were
violated by defendants' acts as alleged herein;
(b) Whether documents, releases and/or statements
disseminated to the investing public and Cholestech's
shareholders during the Class Period omitted and/or
misrepresented material facts about the business and finances
and profitability of the Company;
(c) Whether defendants knowingly or recklessly made
materially false statements or omitted material facts about the
financial condition, earnings power, growth potential and
profitability of the Company;
(d) Whether the market price of the Company's common
stock during the Class Period was artificially inflated due to
the nondisclosure and/or misrepresentations complained of
herein; and
(e) Whether the Class suffered damages and, if so,
the proper measure thereof.
27. A class action is superior to all other available
methods for the fair and efficient adjudication of this
controversy since joinder of all members is impracticable.
Furthermore, as the damages suffered by individual Class
members may be relatively small, the expense and burden of
individual litigation make it impossible for Class members to
individually redress their wrongs. Plaintiffs anticipate no
difficulty in managing this action as a class action.
28. Plaintiffs will rely, in pertinent part, upon the
presumption of reliance established by the fraud-on-the-market
doctrine. The market for Cholestech's common stock was at all
times an efficient market for the following reasons, among
others:
(a) As a regulated issuer, Cholestech filed periodic
public reports with the SEC;
(b) Cholestech's securities volume was substantial
during the Class Period;
(c) Cholestech disseminated information on a market-
wide basis over various electronic media services such as the
Bloomberg newswires and also issued press releases over
BusinessWire; and
(d) The market price of Cholestech's securities
reacted efficiently to new information entering the market.
29. The foregoing facts clearly indicate the existence of
an efficient market for trading of Cholestech securities and
make applicable the fraud-on-the-market doctrine. Plaintiffs
and the Class are thus entitled to a presumption of reliance
with respect to the misstatements and omissions complained of
herein.
BACKGROUND REGARDING CHOLESTECH AND ITS PRODUCT LINE
30. Cholestech was founded in 1989 and has traded
publicly since 1992. The Company's flagship product, the LDX
System, offers a diagnostic testing method which allows for
testing and measuring total cholesterol, high-density
lipoprotein ("HDL") cholesterol, triglycerides and glucose, and
estimating low-density lipoprotein ("LDL") cholesterol by
calculation with a single drop of blood within five minutes.
The LDX System includes the LDX Analyzer and a small variety of
single-use cassettes. The LDX System accounts for
substantially all of the Company's revenue.
31. Cholestech markets the LDX System to the Physician
Office Laboratory ("POL"), Health Promotion and Pharmacy
markets, both nationally and internationally. Cholestech faced
significant obstacles penetrating each of these markets during
the Class Period.
32. The POL market consists of office laboratories in
physicians' offices. With the given state of aggressive
managed care in the healthcare industry, however, physicians
were increasingly outsourcing their lab work:
(a) Managed care would, and did, drive down the
price of multi-phasal panel tests to the point where labs would
charge as little as $10.50 for 12 different tests, compared to
substantially higher pricing for the LDX's cholesterol test;
(b) Insurance companies were reluctant to reimburse
for LDX tests due to precision issues and the likelihood of
needing a confirming lab test in any event; and
(c) Doctors in a managed care setting did not have
time to conduct or supervise in-office blood tests or necessary
quality control testing on the LDX units.
33. Aside from the cost issues associated with managed
care, doctors further need a broader spectrum of tests provided
by a multi-phasal panel than simply the cholesterol results
available from the LDX. Doctors were also, during the Class
Period, more reluctant to handle blood in the office with the
added risks presented by the HIV virus.
34. Cholestech marketed the LDX System into the POL
market through the use of nonexclusive distribution agreements
with at least two national medical products distributors,
General Medical, a division of McKesson Corporation, and
Physician Sales & Services, Inc. The Company also used a
variety of regional distributors.
35. The Health Promotion market includes corporate
wellness programs, fitness centers, health promotion service
providers, community health centers, public health programs,
the military and other independent screeners. During the Class
Period, the Company used regional distributors and screening
organizations to market its products into the Health Promotion
market. Cholestech's greatest challenge in penetrating this
market was insurance reimbursement. If a doctor was not
involved in the testing process, third party reimbursement was
rare.
36. The Pharmacy market targets retail pharmacies.
Cholestech's marketing plan for this market involved developing
a therapeutic monitoring program in conjunction with physicians
and third party reimbursers. Pharmacists were intended under
the program to provide patients with testing and immediate
counseling, including a cardiac risk assessment profile, and
then to encourage patients to discuss the results with their
physicians. With the given state of aggressive managed care,
however, insurance companies were reluctant to reimburse for
duplicate counseling -- first with the pharmacist and then with
the physician. Pharmacists, like physicians, would also be
reluctant to handle blood because of the fear of the HIV virus.
Throughout the Class Period, Cholestech marketed to the retail
Pharmacy market using Bergen Brunswig Drug Company.
37. Of tremendous stated importance to the Company during
the Class Period was the waiver obtained by Cholestech relating
to requirements under the Clinical Laboratory Improvement
Amendments of 1988 ("CLIA"). This waiver allowed the LDX
System to be the only point-of-care multi-analyte system
legally operable by a person without special medical training.
This attribute was intended to make the LDX System attractive
to potential end-users, as they could employ any of their
office workers to use the LDX System, as opposed to needing a
nurse or doctor to perform the testing. The CLIA waiver was
not, however, recognized in all fifty states.
38. Precision and accuracy for the LDX System were issues
facing Cholestech in all three of the Company's target markets.
In fact, a study sponsored by Cholestech in 1996 (the "Kafonek
Study") demonstrated that error rates for total cholesterol,1
triglycerides and LDL cholesterol tests far exceeded error
rates approved by the National Cholesterol Education Program
("NCEP").2 Of the tests performed by the LDX Analyzer, only
the error rate for Cholestech's HDL cholesterol test fell
(narrowly) within the criteria articulated by the NCEP. Error
rates for the LDX, furthermore, more than doubled comparable
error rates for standard lab tests, even for the HDL test.
39. The Kafonek Study is particularly notable both
because Cholestech sponsored it and because the senior author
on the paper discussing the study, Dr. Bachorik, is a
nationally known expert on measuring HDL cholesterol, and
served as Chairman of the NCEP Working Group on Lipoprotein
Measurement. The study concluded that while the Cholestech
desktop analyzer meets the NCEP guideline criteria for testing
HDL cholesterol, "[i]t remains to be seen whether improvements
in desktop analyzer technology can reduce imprecision to the
degree currently obtainable with standardized laboratory
measurements."
40. Further plaguing defendants' marketing efforts during
the Class Period was the significant amount of labor necessary
to maintain the LDX System, notwithstanding the CLIA waiver
(which was not even recognized in all states). Cholestech
Technical Bulletin No. 111 states that although proficiency
testing is not required for facilities testing under a CLIA
waiver, performing and passing proficiency testing is "an
important quality improvement tool." Cholestech further
recommends that quality control tests be run with each new
shipment of cassettes, each new lot of cassettes or any time
there was doubt as to whether cassettes had been properly
stored. Controls were to be run more often in states which did
not recognize the Company's CLIA waiver. See, Cholestech
Technical Service (Website) FAQ's. Also plaguing marketing
efforts for Cholestech's LDX System during the Class Period was
the limited shelf-life and refrigeration requirements for the
System's test cassettes.
41. Cholestech's business model was based on the
"razor/razorblade" theory. That is, the Company was willing to
sell its LDX Analyzer (i.e., the razor) for a very low price
(publicly reported at approximately $1800, although internal
Company documents show the Analyzer was frequently sold for
materially less) to develop a stream of income selling the
high-margin cassettes (i.e., the razorblades) for each use of
the LDX System.
42. To effectuate the fraudulent scheme described herein,
defendants undertook to flood the Company's distribution
channels with LDX Systems (i.e., "stuff the channels") and book
as income 100% of the revenues attributable to product shipped
which defendants knew or recklessly disregarded that end-users
did not want. This practice effectively and artificially
inflated Cholestech's revenues and earnings and, thereby, the
Company's stock. In addition, defendants engaged in a scheme
to increase reported revenues by 15-20% through the use of side
"deals" with distributors. Such "deals," according to internal
Cholestech documents obtained by plaintiffs, were frequently
side agreements which allowed the distributors undisclosed
rights of return for products not sold to end-users.
43. More importantly, by this practice, the Company
fraudulently created an air of market acceptance for its
flagship product. By falsely conveying the impression that
"sales" of the Cholestech LDX Analyzer were to end-users -- as
opposed to product simply being shipped to distributors --
defendants led investors to believe that increased sales of the
LDX System would further lead to increased high margin sales of
the LDX cassettes.
44. Defendants also, during the Class Period, shipped
product to distributors despite explicit agreements with these
distributors not to do so until after the distributor finalized
its sell-through agreement with the end-user.
SUBSTANTIVE ALLEGATIONS
The Class Period Commences With
Cholestech's Secondary Offering
45. On June 28, 1996, Cholestech conducted a secondary
public offering of 2,500,000 Cholestech shares to the investing
public at a price of $5 per share (the "1996 Offering"). The
co-managing underwriters of the offering were Vector Securities
International, Inc. ("Vector Securities") and Principal
Financial Securities Inc. ("Principal Financial"). According
to a press release issued by Cholestech the same day, the
Company planned "to use the proceeds of the 1996 Offering for
research and development related to expansion of test menus,
for capital expenditures related to expansion of manufacturing
capacity, for repayment of indebtedness, for expansion of sales
and marketing activities and for other working capital and
general corporate purposes." Cholestech's proposed uses of the
1996 Offering proceeds suggested that the Company was growing
rapidly and therefore needed increased manufacturing capacity
and expanded sales and marketing activities, and that future
growth would be fueled by successful "research and development"
of new diagnostic tests to be performed through the LDX System.
46. The undisclosed reason underlying Cholestech's 1996
Offering, however, was that the Company was desperate for
money. In order to raise over $13,000,000 from investors,
defendants had to provide the illusion of growth and success.
As evidence of defendants' desperation for the 1996 Offering
proceeds, Cholestech ultimately offered only 2,875,000 shares
(down from the 3,375,000 shares the Company originally
registered with the SEC to sell) and sold such shares to the
public at only $5 per share when the last price for Cholestech
shares the day before the 1996 Offering was $5.75 per share.
Defendants were thus willing to sell Cholestech shares at a 12%
discount to the prevailing market price in order to obtain the
much-needed funds.
47. On July 1, 1996, only three days after the 1996
Offering, Vector Securities initiated coverage of Cholestech
with a "buy" rating and estimated 1996 losses of $0.14 per
share, profit of $0.04 per share in 1997 and a profit of $0.47
per share in 1998.
Cholestech Announces its Q1'97 Financial Results
48. On July 24, 1996, Cholestech reported its financial
results for the first fiscal quarter of 1997 for the three
months ended June 28, 1996. Sales reportedly increased to
$2,760,000, up 102% from sales reported in the first quarter of
the previous year. The net loss for the quarter was $411,000,
or $0.05 per share, down $0.08 per share from the same quarter
of fiscal 1996. Commenting on the results, defendant Pinckert
stated:
This quarter was marked by three significant
milestones for Cholestech. On June 28th we completed
a public offering of common stock, raising
approximately $13 million to use primarily for
repayment of existing debt, funding development of
new tests to add to our Cholestech L.D.X. System and
expansion of manufacturing capacity. In mid-April we
launched our CLIA waived product line into the
physician office laboratory market, utilizing the 700
person sales force of Physician Sales and Service,
Inc. and in May we entered into a co-development and
marketing agreement with Metra Biosystems, Inc. to
develop a test cassette for our System to measure
bone resorption (an indication of osteoporosis.) . .
. . With the proceeds of our public offering, we
believe Cholestech has the resources to develop and
deliver some exciting new diagnostic tests in the
areas of osteoporosis, diabetes management and
prostate cancer.
49. The statements made in the July 24, 1996 press
release were false and materially misleading because defendants
knew or recklessly disregarded that:
(a) Development of new diagnostic tests for use with
the LDX System was delayed, would not meet new product delivery
timeframes and such tests were not likely to be ready to market
for years, if at all, and further that the proceeds from the
1996 Offering were not going to be able to provide all of "the
resources to develop and deliver some exciting new diagnostic
tests in the areas of osteoporosis, diabetes management and
prostate cancer," and that the LDX System would continue as a
one-test system for some time;
(b) The Company reported revenue and earnings in
violation of GAAP, which revenues and earnings were materially
overstated due to defendants' strategy to "stuff the
distribution channel" with excess product and book all such
"deliveries" as revenues and earnings, despite actual knowledge
or reckless disregard for the fact that at the time there was
insufficient demand by end-users for Cholestech's LDX System;
(c) A material portion of the Company's reported
sales were what the Company referred to in internal documents
as "deals," with such "deals" frequently including side
agreements allowing rights of return for products not sold to
end-users; and
(d) According to the allegations by Cholestech's
former CFO in his lawsuit against the Company, discussed below,
defendants were engaging in a pattern of questionable
accounting adjustments and inaccuracies involving the Company's
accounting for obsolete inventory and off-site, re-encoded
cassettes which were not salable.
Cholestech Reports Inflated Earnings
Through the Utilization of
Questionable Accounting Practices
50. Beginning in 1996, if not earlier, defendants engaged
in a scheme to manipulate certain accounting conventions to
artificially present Cholestech as a healthy and growing
company. The details of one aspect of defendants' scheme are
set forth in a complaint filed on or about August 5, 1997 by
Richard Janney, Cholestech's former Chief Financial Officer
against defendants Cholestech and Pinckert in the Superior
Court of the State of California for the County of Alameda,
Case No. H197427-8 (the "Janney Complaint"). According to the
Janney Complaint, from 1992 through 1996, Janney reported
inventory discrepancies to Pinckert, which Pinckert repeatedly
discounted. As the Janney Complaint states:
Of these reported facts, Janney noticed a pattern of
questionable accounting adjustments and inaccuracies,
including but not limited to, with the way Cholestech
accounted for its manufacturing costs and production
results; inventory valuation; obsolete, scrap, and
off-site inventory which resulted in distorted
inventory values being reported on Cholestech's
financial statements, manufacturing reports and
standard costing accounting worksheets. These
adjustments were changing the standard cost to
manufacture products, reversing accounting reserves
for obsolete inventory and inaccurately accounting
for off-site, re-encoded cassettes that were not
salable thus causing large fluctuations in monthly
reporting.
Janney Complaint at ¶15.
51. As a result of defendants' materially misleading
accounting practices, Janney refused to sign the June 30, 1996
Form 10-Q (the "June 1996 10-Q") because, according to the
Janney Complaint, Janney could not in good conscience certify
to the SEC that Cholestech's books and records "were accurate
or had been kept in accordance with general accepted accounting
policies." Janney Complaint at ¶16.
52. The Janney Complaint also states:
Plaintiff is informed and believes and thereon
alleges that, prior to his employment with defendant
Cholestech, and continuing during the period of
plaintiff's employment, defendant Cholestech, with
full knowledge, approval and at the direction of
defendant Pinckert, engaged in numerous schemes
designed to deceive Cholestech shareholders,
investors, accountants and the general financial
community. These schemes violated Generally Accepted
Accounting Principles and the Federal Securities and
Exchange Act of 1934, 17 U.S.C. § 78a; the Federal
Securities Act of 1933, and included, inter alia:
inappropriate adjustments to inventory standard
costs, reversing accounting reserves for scrap and
obsolete inventory and inaccurately accounting for
off-site, re-encoded cassette inventory.
Janney Complaint at ¶25.
53. As a result of Janney's refusal to engage in
defendants' scheme to mislead the investing public as to
Cholestech's true financial condition, Pinckert terminated
Janney and signed the June 1996 10-Q himself as the Company's
"Principal Financial and Accounting Officer." Janney Complaint
at ¶18.
54. Had Pinckert complied with GAAP and otherwise heeded
Janney's expert advice, Cholestech would have reported
materially lower revenue and worse earnings, which would have
led to a sharp drop in Cholestech's share price. As a result,
investors in the 1996 Offering would have been outraged to
learn the true condition of the Company so soon after
defendants had assured them of Cholestech's bright future. In
addition, such a disclosure only four weeks after the 1996
Offering would have likely led to litigation by defrauded
investors, among others, and would have shattered Cholestech's
plans to raise funds from public investors in the future.
55. At no time did Cholestech ever disclose the
disagreements that led to Janney's termination, nor did
Cholestech disclose the serious nature of the Janney
allegations to the investing public.
Cholestech Fails to Disclose Its Reliance
on Extraordinary "Deals"
56. Plaintiffs have obtained internal corporate documents
outlining the extent to which defendants used side deals to
artificially inflate revenues throughout the Class Period.
Backing out these extraordinary deals shows that but for the
"deals," Cholestech would have reported substantially lower
revenues, as depicted by the following chart:
[no chart with document's computer file]
57. The internal data also demonstrates that defendants'
use of these extraordinary deals hit an all-time high in the
fourth quarter of fiscal 1998, just prior to the Company's
announcement of its proposed secondary offering. In fact,
special deals in Q4'98 were more than twice as high as each of
the previous three quarters, as depicted by the following
chart:
[no chart with document's computer file]
Cholestech Continues to Report "Increased Earnings"
58. On August 22, 1996, at Cholestech's Annual Meeting of
Shareholders, Cholestech amended its 1988 Stock Incentive
Program to increase the aggregate number of shares of stock
authorized for issuance thereunder by 500,000. This was a huge
increase from the last amendment to the 1988 Program in 1995,
which increased the number of shares authorized to be issued by
only 250,000. Defendants engaged in this scheme just at the
outset of the Class Period in order to set in motion a plan to
enrich themselves through the grant of huge amounts of low-
priced stock options which they could exercise and sell to the
investing public at artificially inflated prices.
59. On September 17, 1996, Cholestech announced that it
had signed a distribution agreement with General Medical
Corporation. Terms of the agreement called for General Medical
to distribute the LDX System to more than 200,000 medical
provider organizations in the United States. Pinckert stated
in the September 17 press release that General Medical had
"more than 600 account managers nationwide who are very well
positioned to deliver our product into their target markets.
The addition of General Medical almost doubles the number of
professional sales people selling our System to the physician
office laboratory market."
Cholestech Announces Q2'97 Financial Results
60. On October 30, 1996, Cholestech reported its
quarterly financial results for the period ended September 27,
1996. Net sales for the quarter were reported to be
$3,056,000, an increase of 95% over the same quarter in fiscal
1996. The net loss for the quarter was reported to be
$237,000, or $0.02 per share, a reduction of 62% and 75%,
respectively, over the same fiscal quarter of 1996. Commenting
on the results, Pinckert stated:
We are pleased with our continued progress
toward the short term goal of profitability. Not
only did we sustain our sales growth, but our gross
margin also continued to improve in the second
quarter of fiscal 1997. Further, our operating
expenses growth of 35% remains well below our sales
growth. Through September, we have shipped 460
Cholestech LDX Systems into the physician office lab
market. With Physicians Sales and Service and
General Medical, we are represented by the two
largest distributors to physicians offices with
approximately 1,300 professional sales
representatives between them. This quarter we added
two new regional distributors to service the health
promotion market. We added Alabama and Georgia to
our list of Blue Cross accounts and Blue Cross of
California has added 10 new hospitals. We are now
represented in 105 Blue Cross hospitals in
California. The pharmacy market is also beginning to
take shape. Our pilot program will add approximately
80 new pharmacy sites in December with further
expansion planned for April/May of 1997. Our plans
to launch into the pharmacy market in calendar 1997
remain on track.
61. The statements made in the October 30, 1996 press
release were false and materially misleading because defendants
knew or recklessly disregarded that the development of the
Pharmacy market was not "beginning to take shape." In fact,
Cholestech was having difficulty finding pharmacies interested
in the LDX System and was unable to contract with distributors
for the Pharmacy market due to lack of interest by the largest
national chain drug stores. In addition, Pinckert failed to
disclose that development of the Pharmacy market was failing to
materialize due to insurance reimbursement issues and a growing
reluctance in the health-care field to handle blood outside a
laboratory setting.
62. On November 26, 1996, Andrea J. Tiller ("Tiller") was
appointed Cholestech's Vice President of Finance and Chief
Financial Officer. One of Tiller's main responsibilities as
CFO was to communicate defendants' false and/or overly-
optimistic views about Cholestech to the SEC, securities
analysts and investors.
Cholestech Announces Q3'97 Financial Results
63. On January 29, 1997, Cholestech reported its
financial results for the third quarter of fiscal 1997.
Revenues were reported by Cholestech as having reached $3.2
million, a 96% increase over the $1.6 million reported in the
same period the prior year. The Company's net loss was reduced
to $163,000, or $0.01 per share, from $699,000, or $0.09 per
share in the comparable quarter the prior year. According to
defendant Pinckert,
We continue to track on our plan toward
sustained profitability. . . . By quarter end we had
1231 active Health Promotion accounts, 27 percent
more than the accounts at the end of the second
quarter. The installed base of Cholestech LDX
Systems in the physician office lab market increased
to 924 units, a 57 percent increase over the units
installed at the end of the second quarter. In our
newest market, the pharmacy market, we are pleased to
report we have trained and shipped product to 134
pharmacy sites to date. These facts are fueling this
quarter's 148% growth rate in domestic sales compared
to the third quarter of last year, and we believe
will continue to fuel growth in the future.
64. The statements made in the January 29, 1997 press
release were false and materially misleading because defendants
knew or recklessly disregarded that:
(a) The Company's internal controls were completely
inadequate and only accounted for sales to distributors and did
not track sell-through to end-users and that, therefore, there
was no reasonable basis for any statement by the Company
regarding the number of "active Health Promotion accounts," the
number of LDX Systems installed in physician office labs, or
sites at which the LDX System was available; and
(b) Development of the Pharmacy market was not
"fuel[ing] growth." In fact, Cholestech was having difficulty
finding pharmacies interested in the LDX System and was unable
to contract with distributors for the Pharmacy market due to
lack of interest by the largest national chain drug stores. In
addition, Pinckert failed to disclose that the development of
the Pharmacy market was failing to materialize due to insurance
reimbursement issues and a growing reluctance in the health-
care field to handle blood outside a laboratory setting.
65. Upon information and belief, based on information
supplied by someone with knowledge of Cholestech's business,
sometime during March 1997, Cholestech demanded that two of its
distributors, Health Management Systems and another
distributor, take significant orders of LDX Systems that the
distributors did not want. In fact, Cholestech was so
desperate to consummate the "sale" that the Company offered to
purchase refrigerators for Health Management Systems so that it
could prolong the limited shelf-life of the unwanted cassettes.
66. Cholestech thereafter announced, on April 3, 1997,
that it signed a two-year, minimum $2 million agreement with
Health Management Systems Corporation to offer consumers
testing of individual cholesterol levels using the LDX System
at selected Wal-Mart stores across the country.
67. The statements made by Cholestech regarding the Wal-
Mart contract were false and materially misleading because,
according to information obtained by plaintiffs' counsel, the
parties had not agreed to a "minimum" payment to Cholestech of
$2 million. Rather, the $2 million figure was merely what was
projected by Cholestech to be received and there was no penalty
if Cholestech's sales did not reach $2 million. Such false and
misleading statements by the defendants were material
considering that for the third quarter of fiscal 1997,
Cholestech's total sales were only $3.2 million. Further, the
misleading statements regarding the Wal-Mart contract created
the false impression that the LDX System was becoming accepted
by the market if the largest retailer in the country supported
the program, and that this market acceptance would provide for
additional future sales.
68. On April 16, 1997, Cholestech announced that it had
signed a multi-year agreement with AmeriSource Health
Corporation ("AmeriSource") to distribute the LDX System
nationwide to pharmacies. According to Cholestech's press
release, the agreement guaranteed a minimum of $7 million to
the Company over the first two years, with a provision for the
negotiation of a third year. According to Pinckert, "[o]ur
agreement with AmeriSource will benefit both pharmacies and
their customers as well as both companies."
69. The statements contained in the April 16, 1997 press
release were materially misleading because Pinckert gave the
false impression that the agreement with AmeriSource would lead
to sharply increased sales for the LDX System in the Pharmacy
market, a market not previously penetrated by the Company.
Pinckert failed to disclose that the distribution agreement
with AmeriSource did not require AmeriSource's salespeople to
sell LDX Systems and that, therefore, there was no reasonable
basis for projecting, let alone "guaranteeing," $7 million for
the Company. In addition, Pinckert failed to disclose that
development of the Pharmacy market was failing to materialize
due to insurance reimbursement issues and a growing reluctance
in the health-care field to handle blood outside a laboratory
setting.
Cholestech Announces Q4'97 Financial Results
70. On April 30, 1997, Cholestech reported its financial
results for its fourth fiscal quarter of 1997 and fiscal year
1997, ended March 28, 1997. Revenues for the fourth quarter
reportedly rose to $3.9 million, a 67% increase over the $2.3
million in sales reported in the fourth quarter of fiscal 1996.
The Company reported net income of $2,000, or $0.00 per share,
compared to a loss of $753,000, or $0.09 per share the prior
year. Defendant Pinckert stated: "[w]e are very pleased with
the progress made this year. Our stated goals were to continue
to grow our health promotion business, launch into the
physician office lab market, and leverage our technology. We
achieved what we set out to do. We are now approaching our
goal of sustainable profitability."
71. Pinckert continued:
Our initial target, health promotion, remains
the primary driver of our growth. Going forward, we
intend to leverage the opportunity provided by the
Wal-Mart agreement to further develop this market.
We began selling to physician office labs in 1997 and
by the end of the fourth quarter, were generating
almost 20 percent of our revenues from these
customers. Our goal in the pharmacy market was to
prepare for launch into pharmacies in fiscal 1998.
That launch will be enhanced by our distribution
agreement with AmeriSource. We believe as we enter
fiscal 1998 we are well positioned for continued
growth in all our markets.
72. In the same press release, the Company further
touted its ability to develop add-on tests to the LDX System.
Such add-ons were to be a catalyst for growth in the future as
a customer would be able to get additional diagnostic tests
performed on the LDX System with the same single drop of blood.
The Company stated:
During the year, the company leveraged its
technology by signing an agreement with Metra
Biosystems to develop and market a cassette for the
Cholestech LDX System to assess bone resorption.
Cholestech also received a grant from the National
Diabetes and Kidney Disease Advisory Council of the
National Institutes of Health for research related to
developing a single test disposable cassette to
measure glycated hemoglobin, a valuable tool in the
treatment of diabetes. The Cholestech LDX System
currently provides diagnostic screening and
therapeutic monitoring of cholesterol and glucose
levels.
73. The statements made in the April 30, 1997 press
release were false and materially misleading because defendants
knew or recklessly disregarded that:
(a) Information obtained from internal Cholestech
documents demonstrates that although the Company reported
revenue of $3.9 million, approximately 6% or $230,000 of the
reported revenue was attributed to extraordinary "deals."
These internal documents further reveal that Cholestech sold a
total of 539 LDX Analyzers in Q4'97, of which 200 Analyzers or
37% were the result of "deals." When Pinckert stated that the
POL market was "generating almost 20 percent of [Cholestech's]
revenues," he failed to disclose that 200 of the 220 LDX
Analyzers sold in this market consisted of "deals;"
(b) The Company's reported revenues and earnings
were materially overstated and the Company was not "approaching
[its] goal of sustainable profitability" due to defendants'
strategy to "stuff the distribution channel" with excess
product and book all such "deliveries" as revenues and
earnings, despite actual knowledge or recklessly disregarding
that at the time that there was insufficient demand from end-
users for Cholestech's LDX System;
(c) Development of new diagnostic tests for use with
the LDX System was delayed, the Company was not "leverag[ing]
its technology," and such tests were not likely to be ready to
market for years, if at all, and the LDX System would be a one-
test analyzer for some time to come; and
(d) The previously announced Wal-Mart contract was
not providing "leverage" for further "opportunities" to develop
the Health Promotion market because the Wal-Mart contract did
not provide for a minimum number of tests to be provided or a
minimum amount of revenue to be received by Cholestech despite
specific references in defendants' April 3, 1997 press release
to Cholestech receiving a "minimum" of $2 million from the Wal-
Mart contract.
74. On July 21, 1997, Cholestech filed its Annual Proxy
Statement with the SEC (the "1997 Proxy"). The 1997 Proxy was
the first time defendants revealed the massive and excessive
stock options granted to Pinckert under the 1988 Stock
Incentive Program. Under the 1988 Stock Incentive Program,
amended shortly after the beginning of the Class Period to
allow Cholestech insiders the authority to grant themselves
hundreds of thousands of stock options, Pinckert was granted
115,000 options to purchase Cholestech stock at a price of
approximately $4.50 per share. By the time the public learned
on July 21, 1997 of defendants' massive grant of the options,
Cholestech's shares traded at $6-7/8 per share. By contrast
and as further evidencing defendants' scienter, in 1996
Pinckert was granted only 10,000 shares under the 1988 Stock
Incentive Program, or less than 10% of the number of options
granted to Pinckert in 1997.
Cholestech Announces Q1'98 Financial Results
75. In a press release dated July 30, 1997, Cholestech
reported its financial results for its first fiscal quarter of
1998, ended June 27, 1997. The Company reported that for the
first time in its history, the Company had operating
"profitability." The Company reported operating profit of
$4,000 and net profit of $122,000, or $0.01 per share compared
to an operating loss of $388,000 and a net loss of $411,000, or
$0.04 per share in the same quarter the year prior. Revenues
purportedly jumped 52% to $4.2 million from $2.8 million in the
same quarter the prior year.
76. In the foregoing press release touting the Company's
first-time profitability, defendant Pinckert stated: "This was
a record quarter for both revenues and profitability. We have
taken another significant step toward our goal of sustainable
profitability. I am proud of Cholestech's execution of our
leverage strategy during the quarter, delivering strong revenue
growth while effectively managing costs to expand profits."
77. The statements made in the July 30, 1997 press
release were false and materially misleading because defendants
knew or recklessly disregarded that although the Company
reported revenue of $4.2 million, approximately 17% or $719,000
of the reported revenue was attributed to special "deals."
Furthermore, internal Cholestech documents obtained by
plaintiffs reveal that Cholestech sold a total of 1122
Analyzers in this quarter, of which 626 or 56% were the result
of "deals." More than half of all the Analyzers sold were
based on "deals." This was a 19% increase in "deals" over the
prior quarter. While CEO Pinckert touted Cholestech's
profitability milestone, he failed to disclose that the
Company's success was an illusion, due in reality to increasing
the number of special "deals" to distributors which were
actually fraudulent sales.
78. On August 22, 1997, Cholestech held its Annual
Meeting of Shareholders, and adopted the 1997 Stock Incentive
Program (the "1997 Plan") authorizing reservation of 900,000
shares of Cholestech stock for issuance thereunder. The number
of shares reserved for issuance to Cholestech insiders was
almost double the 500,000 shares reserved in the 1996 amendment
to the 1988 Plan and almost four times the number of shares
reserved in the 1995 amendment to the 1988 Plan. The 1997 Plan
was adopted because the 1988 Plan (as amended) was scheduled to
expire in February 1998. Undisclosed at the time of
authorization of the 1997 Plan was that Pinckert was to be the
greatest beneficiary, by far, under the 1997 Plan and that
defendants were currently engaged in a scheme to artificially
inflate the price of Cholestech's stock to maximize Pinckert's
profit under the Plan.
79. In September 1997, Pinckert disseminated a "Dear
Shareholder" letter to Cholestech investors. In the "Fiscal
Year 1997 In Review" section of the letter, Pinckert
highlighted some of the Company's "accomplishments." He stated
that:
With the granting of the CLIA waiver, we began
selling into the Physician Office Lab (POL) market.
By the end of Fiscal 1997, we had placed 1144
Cholestech LDX Systems at POL sites. In addition, in
the first quarter of Fiscal 1998, another 615 Systems
were placed, bringing our total to 1759 customers in
the POL. This market segment now accounts for about
20 percent of our revenues.
Health Promotion (preventive care screening),
which became the main focus of our marketing efforts
when CLIA was implemented back in 1992, continues to
account for the majority of our business. We have 13
regional distributors around the country that service
this market. Two of them reached gold level this
past year, each contributing $500,000 in sales of
Cholestech products to their customers. At the end
of first quarter of Fiscal 1998 we had 1562 Health
Promotion accounts. This represents a 6% increase
over the 1475 accounts at the end of fiscal 1997.
In March of this year we signed a two year,
minimum $2 million agreement with Health Management
Systems of Richardson, TX to offer cholesterol
screenings at more than 2,200 Wal-Mart stores across
the country. The response from Wal-Mart customers
thus far has been very favorable. Through the end of
July, screenings have taken place at approximately
500 stores in 14 states. In June and July alone,
roughly 21,000 people were tested.
80. Pinckert's statements related to Cholestech's
"installed base" had no reasonable basis because Cholestech
only estimated the number of "installed" Analyzers from the
number of Analyzers shipped to distributors, without regard to
whether the product was selling through to end-users. Upon
information and belief, the true "installed base" was
substantially below the number of units set forth above.
Defendants' use of the term "installed base" was particularly
material in light of Cholestech's razor/razorblade business
strategy, as it created the impression the Company stood to
profit from high-margin sales of LDX cassettes.
81. In addition, statements made by Cholestech regarding
the Wal-Mart contract were false and materially misleading
because the parties had not agreed to a "minimum" payment to
Cholestech of $2 million as represented. Rather, the $2
million was merely a number arbitrarily projected by Cholestech
to be received, and there was no penalty if sales did not reach
the arbitrary number.
82. On October 9, 1997, Cholestech disseminated a press
release which reported that the Company and Parke-Davis, a
division of Warner Lambert Company and Pfizer, Inc., reached an
agreement valued at $1 million whereby the LDX System was to be
used in a Phase IV clinical trial. Cholestech distributed the
press release to the investing public in order to suggest that
the scientific and clinical testing communities were adopting
the Cholestech technology and that scientific acceptance of the
LDX System was growing.
83. On October 13, 1997, Genesis Merchant Group
Securities ("Genesis") initiated coverage of Cholestech with a
"long-term buy" rating and set an eighteen-month price target
of $23 per share. Genesis analyst Christopher Tihansky stated,
based on information provided to him by defendants, including
Cholestech's CFO Tiller: "[w]e believe Cholestech is emerging
as one of the clear leaders in the burgeoning disease
management market." According to Tihansky, several factors
would pique investor interest in Cholestech over the next
several quarters, including that Cholestech would be able to
differentiate its position in the cholesterol and glucose
testing markets and Cholestech would expand its test menu,
broaden its distribution system, and grow its sales and
earnings significantly over the next several years. As for
Cholestech's revenue growth, Tihansky stated:
Over the next several years, we expect Cholestech's
revenue growth to be fueled by an increasing
installed base of LDX analyzers, which will drive
consumption of disposable test cartridges. As of the
end of Q1:FY98, Cholestech had an installed base of
6,600 analyzers. We expect the installed base will
grow to 10,000 analyzers by the end of FY98, 17,000,
by FY99, and 25,000 by FY2000. We expect cartridge
volumes to grow from 1.9 million units in FY97 to 2.6
million in FY98, 4.7 million in FY99, and 7 million
in FY2000.
At the date of Tihansky's research report, Cholestech's stock
was trading at approximately $13-1/4 per share.
84. The statements disseminated in the October 13, 1997
Genesis analyst research report were false and materially
misleading because defendants, who provided the information to
analyst Tihansky and/or endorsed his report, knew or recklessly
disregarded that:
(a) The Company's reported and projected revenues
and earnings were materially overstated due to defendants'
strategy to "stuff the distribution channel" with excess
product and book all such "deliveries" as revenues and
earnings, despite actual knowledge at the time that there was
insufficient demand from end-users for Cholestech's LDX System;
(b) A material portion of the Company's reported
sales were what the Company referred to in internal documents
as "deals" and that such "deals" frequently included side
agreements which allowed rights to return products not sold to
end-users;
(c) The Company's internal controls were completely
inadequate, only accounted for sales to distributors and did
not track sell-through to end-users, and that there was,
therefore, no reasonable basis for defendants' statements,
through Tihansky, regarding the size of Cholestech's installed
base and the rapid growth projected in such installed base; and
(d) Development of new diagnostic tests for use with
the LDX System was delayed, would not meet new product delivery
timeframes and that such tests were not likely to be ready to
market "over the next several quarters," if at all.
85. On October 28, 1997, two weeks after initiating
coverage, Genesis raised its rating on Cholestech to "buy" from
"long term buy," and moved the $23 price target on Cholestech's
stock from eighteen months to twelve months.
Cholestech Announces Q2'98 Financial Results
86. On October 29, 1997, Cholestech issued a press
release over BusinessWire announcing financial results for the
Company's second fiscal quarter of 1998, ended September 28,
1997. The Company reported revenues of $5.4 million, a 77%
increase over the $3.1 million reported in the same quarter a
year earlier. Profits were reported as $437,000, or $0.04 per
share, compared with a net loss of $237,000, or $(0.02) in the
same period the previous year.
87. In the same press release, defendant Pinckert stated:
The ongoing implementation of our business strategy
continues to fuel our growth. In the second quarter
we achieved strong growth in our health promotion and
physician office lab businesses. . . . This quarter's
results reflect our ongoing strategy to leverage our
strategic partnerships to increase market presence,
our technical and development strengths to maintain
product leadership, and our financial model to build
a strong, profitable company for our shareholders.
88. The statements made in the October 29, 1997 press
release including, inter alia, that the Company's "ongoing
implementation of [its] business strategy continue[d] to fuel
[its] growth" and that the Company's "financial model
[reflected the Company's strategy] to build a strong,
profitable company for our shareholders," were false and
materially misleading because defendants knew or recklessly
disregarded that:
(a) Although the Company reported revenue of $5.4
million, approximately 11% or $575,000 of the reported revenue
was attributable to special "deals." Furthermore, internal
Cholestech documents reveal that Cholestech sold a total of
1189 Analyzers in this quarter, of which 500 Analyzers or 42%
were the result of "deals." The Company actually sold only 67
more Analyzers than the prior quarter. Although Pinckert
touted strong growth in the Health Promotions and POL markets,
in actuality, the number of Analyzers sold in the Health
Promotions market dropped from 273 Analyzers in Q1'98 to 241
Analyzers in Q2'98 and, additionally, 68% of all LDX Analyzers
sold into the POL market were the result of "deals;" and,
(b) The development of new diagnostic tests for use
with the LDX System was delayed, that the Company was not
"leverag[ing its] technical and development strengths to
maintain product leadership," and that such new products would
not be ready to market in the near-term, if at all.
89. On December 4, 1997, Genesis analyst Tihansky
reiterated his "BUY" recommendation and his 18-month price
target of $23 on Cholestech.
90. On January 5, 1998, Investor's Business Daily
published a story about Cholestech in its "New America" column
which highlighted small, fast-growing companies. In the
article, Cholestech was cited as claiming that the LDX System's
ease-of-use had led to over 100,000 patient cholesterol
screenings at Wal-Mart stores in fifteen states. Cholestech
also touted its strength in the Pharmacy market. Pinckert
stated, "[w]e're going to put pharmacists into the mainstream
of healthcare."
91. Statements in the January 5, 1998 Investor's Business
Daily were false and materially misleading, however, because
Cholestech had no reasonable or workable plan to "put
pharmacists into the mainstream of healthcare." In fact,
Cholestech was having difficulty finding pharmacies interested
in the LDX System and was unable to contract with distributors
to the Pharmacy market because of the lack of interest by the
largest national chain drug stores. In addition, Pinckert
failed to disclose that the development of the Pharmacy market
was failing to materialize due to insurance reimbursement
issues and a growing reluctance in the health-care field to
handle blood outside a laboratory setting.
92. On January 12, 1998, Vector Securities analyst
Benjamin C. Andrew issued a research report on Cholestech
entitled "This Baby Is A Keeper" in which he placed a "BUY"
recommendation and an $18 price target on Cholestech's stock.
In a section of the report related to Cholestech's distribution
system, Andrew wrote:
As the bulk of its distribution is performed by third
parties over which it has no direct control (though
the company does coordinate and conduct some
marketing itself), Cholestech is able to keep its
sales and marketing expenses very low. The potential
downside of this arrangement, however, is that should
those distributors falter . . . it puts Cholestech's
revenues at risk, as is the case in the pharmacy
market. However, what we have seen in the POL market
is that the portfolio approach to distribution that
Cholestech employs has provided some stability to its
overall revenue growth. . . .
93. The statements made in the January 12, 1998 Vector
Securities research report were false and materially misleading
because defendants knew or recklessly disregarded that the
"portfolio approach to distribution that Cholestech employs"
did not provide "stability to its overall revenue growth"
because defendants' undisclosed strategy was to "stuff the
distribution channel" with excess product and book all such
"deliveries" as revenues and earnings, despite actual
knowledge, at the time, that there was insufficient demand from
end-users for Cholestech's LDX System.
Cholestech Announces Q3'98 Financial Results
94. On January 28, 1998, Cholestech issued a press
release over BusinessWire reporting results for the Company's
third fiscal quarter of 1998. For the three month period ended
December 26, 1997, the Company recorded revenues of $5.7
million, a 78% increase over the $3.2 million reported in the
same quarter the previous year. Net income was reported as
$584,000, or $0.05 per share, compared to a net loss of
$163,000, or $0.01 per share reported for the same quarter the
year earlier.
95. In the same January 28, 1998 press release, defendant
Pinckert stated:
Our business strategy continues to deliver strong
growth, resulting in this quarter's record 8 percent
operating margin. During the quarter we shipped a
record number of Cholestech LDX Systems, a 200
percent increase over the same quarter a year ago.
These systems will expand our growing installed base,
and will enhance our ability to sell more disposable
cassettes in the future. In addition, we have
continued to improve gross margins despite the
challenges we face as capacity is increased to meet
demand.
96. The statements made in the January 28, 1998 press
release including, inter alia, that the Company's "business
strategy continues to deliver strong growth," that the market
for LDX Systems had increased "200 percent" and that the
Company was facing challenges increasing capacity "to meet
demand," were false and materially misleading because
defendants knew or recklessly disregarded that:
(a) Although the Company reported revenue of $5.7
million, approximately 12% or $709,000 of the reported revenue
was attributed to special "deals." Furthermore, internal
Cholestech documents reveal that Cholestech sold a total of
1661 Analyzers in this quarter, of which 617 Analyzers or 37%
were the result of "deals." Pinckert stated that the Company
"shipped a record number of Cholestech LDX Systems..." but
failed to disclose that the number of deals increased from 575
"deals" in Q2'98 to 709 "deals" in this quarter. Forty-one
percent of all LDX Analyzers sold in this quarter were
attributed to "deals;" and
(b) Reported revenues and earnings were materially
overstated due to the defendants' strategy to "stuff the
distribution channel" with excess product and book all such
"deliveries" as revenues and earnings, despite actual knowledge
or reckless disregard that at the time that there was
insufficient demand from end-users for Cholestech's LDX System.
97. On March 31, 1998, The Red Chip Review disseminated a
research report on Cholestech touting the Company's sales and
distribution capabilities. Under a heading entitled "Hitting
Another Record," Red Chip analyst Kenneth E. Thomas stated:
[Cholestech] rang up its 13th consecutive quarter of
sequential growth with a 78% improvement in its top
line to $5.6 million vs. $3.2 million for the
corresponding period last year. The strong
performance was again driven by its ongoing success
in penetrating physicians' labs, hospitals, managed
care organizations, public health departments, and
other health care and service organizations. At the
end of December, the Company had shipped
approximately 3,000 LDX Systems into the physician
office laboratory market.
Information about the number of LDX Systems shipped into the
POL market could only have come from defendants. Such
information was, however, materially false and/or misleading
because "shipments" reported by defendants were not to end-
users, but to the distribution channel and did not accurately
reflect demand for the LDX System.
98. On April 27, 1998, Genesis analyst Tihansky, based on
information, guidance and endorsements he received from
Pinckert and Tiller, issued a brief note on Cholestech
reiterating his "BUY" recommendation and $23 price target,
stating: "Over the next two years, we anticipate that
Cholestech will enjoy increased test volume for its LDX point-
of-care diagnostic system coming from a broader base of
customers. This should fuel revenue growth of 65%, with
earnings doubling each year."
99. Also, during April 1998, Cholestech was notified by
one of its three national distributors for the Pharmacy market
that the distributor had discontinued carrying Cholestech's
products, representing an enormous blow to Cholestech's
purported plans to "fuel growth" by entering the Pharmacy
market and further evidencing that the LDX Analyzer was not
meeting with market acceptance from pharmacists. Defendants
deliberately withheld this information for the investing
public, however, because within days Cholestech was planning to
announce its secondary stock offering worth approximately $56
million to the Company. Announcing such bad news would have
caused Cholestech's stock price to decline and threatened the
viability of the proposed secondary stock offering as well as
decreasing the value of the stock options held by Cholestech
insiders.
Cholestech's Proposed Secondary Offering
100. In furtherance of the next step in defendants'
scheme, Cholestech announced on April 29, 1998 that the Company
filed a draft Registration Statement with the SEC for a
secondary stock offering of 3,450,000 shares, including over-
allotment shares, for anticipated proceeds of $56 million.
101. Nowhere in the Registration Statement did defendants
disclose the ongoing litigation with former CFO Janney, or his
serious allegations of financial improprieties and securities
fraud against the Company.
Cholestech Announces Fiscal 1998 Financial Results
102. On the same day defendants announced the Company's
proposed secondary offering, Cholestech disseminated its
financial results for the fiscal year ended March 27, 1998,
announcing that "increased demand for the Company's products,
improving gross margin, and continued control of expenses
combined to deliver net income of $2.0 million in the fiscal
year ended March 27, 1998, or $0.17 per share (diluted), up
from an $809,000, or $0.08 per share (diluted) net loss in the
prior fiscal year."
103. The April 29, 1998 press release further stated that
revenue for the fiscal year ended March 27, 1998 was $21.7
million, a 68% increase over the $12.9 million reported in
fiscal 1997. According to the Company, gross margin improved
throughout the year, reaching 51% of revenue for the fiscal
year versus 46% of revenue in the prior fiscal year. In
addition, gross profit of $11.2 million increased 89% on the
68% increase in revenue.
104. Expanding on the reported financial results,
defendant Pinckert stated:
Fiscal 1998 was an exciting year for Cholestech.
During the year, the Company broadened its strategic
partnerships to include Parke-Davis and Wal-Mart.
Customer response has been enthusiastic and, coupled
with our internal efforts to maintain our cost
structure, has allowed Cholestech to deliver $2
million of net income to shareholders in our first
year of profitability.
105. The statements made in the April 29, 1998 press
release including, inter alia, that "customer response has been
enthusiastic" and "internal efforts to maintain our cost
structure," were false and materially misleading because
defendants knew or recklessly disregarded that:
(a) Reported revenues and earnings were materially
overstated and that under GAAP Cholestech had not earned
anywhere near "$2 million of net income to shareholders" due to
the defendants' strategy to "stuff the distribution channel"
with excess product and book all such "deliveries" as revenues
and earnings, despite actual knowledge, at the time, that there
was insufficient demand from end-users for Cholestech's LDX
System; and
(b) Although the Company reported revenue of $6.4
million, approximately 24% or $1,552,000 of the reported
revenue was attributed to "deals." Furthermore, internal
Cholestech documents reveal that Cholestech sold a total of
1890 Analyzers in this quarter, of which 1350 Analyzers or 71%
were the result of "deals." Pinckert failed to disclose that
in Q4'98, the total number of special deals more than doubled
from the prior period. After backing out revenue from the
"deals," Cholestech should have reported materially lower
revenue and earnings in Q4'98. According to internal
Cholestech documents, the Company's revenue, including the
"deals," was $6,427,000. These internal documents indicate
that $1,552,000 of the total revenue was derived from "deals."
Subtracting the amount earned from "deals," from the amount
actually reported, the Company should have reported revenue for
Q4'98 as $4,875,000, materially less than the $6,427,000
reported. The Company further failed to disclose that
international sales for the LDX Analyzer decreased dramatically
in this quarter compared to the prior quarter. Cholestech
internal documents reflect that in Q3'98 the Company sold 472
Analyzers internationally, but in Q4'98 the Company only sold
96. Domestic sales of LDX Analyzers also decreased in this
quarter to 924 Analyzers from 1189 in the prior quarter. In
the Health Promotion sector, 600 of the 757 LDX Analyzers sold
were attributed to "deals." Ninety-seven percent of the
Company's total revenue for this quarter from Analyzers was
attributed to "deals."
106. On or about April 29, 1998, Cholestech disseminated
its 1998 Annual Report to Shareholders (the "1998 Annual
Report"). The 1998 Annual Report includes a letter to
shareholders signed by Pinckert and Harvey Sadow, Cholestech's
Chairman of the Board. The letter states, inter alia, as
follows:
Fiscal 1998 was a year that many of us had been
waiting for. We are pleased to be able to say that
during the past fiscal year we have met or exceeded
many of our goals, not only in the financial arena,
but operationally as well.
By increasing the demand for our products, and
by controlling our expenses, we have been able to
exert the kind of financial leverage that results in
increased gross margins and, for the first time,
company profitability. . . .
The core of our business, Health Promotion,
remains robust. Our regional distribution and
screening partners continue to expand the
opportunities for diagnostic screening. These
screenings take place in corporate wellness programs,
lipid clinics, and fitness centers-anywhere that
people desire to control their cholesterol. An
example of this is the screening program in Wal-Mart
stores nationwide.
One of Cholestech's goals is to exploit and
extend the flexibility of the Cholestech LDX platform
with a continuing focus on new product development.
Now in development are a liver function test, a
glycated hemoglobin test for improved diabetes
management, and a bone resorption test for the
management of osteoporosis.
Whether it is the detection or monitoring of
cardiovascular disease, diabetes, or osteoporosis,
our strategy of putting the patient at the center of
care resonates with the desire of today's consumers
to take greater control of their health.
107. In a section of the 1998 Annual Report entitled
"Where Do We Go From Here?" the Company states:
We begin by leveraging the unique capabilities of the
Cholestech LDX System, expanding our installed base
to meet the needs of as many people as possible. Our
installed base increased significantly in fiscal
1998, and as more of our new diagnostic panels come
online, we envision a healthy demand for our existing
test panels, as well as for these new tests. And
while we are extremely pleased with the results of
our current efforts for simple, high-volume
cholesterol testing, we also plan to increase our
marketing efforts surrounding the new testing
portfolio.
Additionally, we continue to solidify and expand
our agreements with major distributors. This enables
us to maintain an aggressive push into our core and
emerging markets of health promotion, physician
office labs, and pharmacies -- all of which have to
this point been only minimally penetrated.
108. The statements made in the 1998 Annual Report
including, inter alia, that the Company was focusing on "new
product development," that the Company "continue[s] to solidify
and expand [its] agreements with major distributors"and that
the "installed base increased significantly in fiscal 1998,"
were false and materially misleading because defendants knew or
recklessly disregarded that:
(a) There was no "healthy demand" for Cholestech's
products, reported revenues and earnings were materially
overstated, and under GAAP, Cholestech was not profitable in
fiscal 1998, due to the defendants' strategy to "stuff the
distribution channel" with excess product and book all such
"deliveries" as revenues and earnings, despite actual
knowledge, at the time, that there was insufficient demand from
end-users for Cholestech's LDX System; and
(b) A material portion of the Company's reported
sales were what the Company referred to in internal documents
as "deals" and that such "deals," in reality, were frequently
side agreements which allowed rights of return on products not
sold to end-users.
Misrepresentations to the San Jose Mercury News
Regarding Cholestech's Installed Base
109. On April 30, 1998, the San Jose Mercury News
published a story about Cholestech's past and prospects. In
the article, defendant Pinckert stated that Cholestech's
installed base of LDX Systems was 10,000, up from 5,000 the
prior year. Pinckert further stated that the installed base of
LDX Systems would rise to 13,000 by the end of 1998.
110. The statements attributed to defendant Pinckert in
the April 30, 1998 San Jose Mercury News article regarding the
number of installed LDX Systems were false and materially
misleading because defendants had no idea what the Company's
actual installed base was because Cholestech used the number of
units shipped to distributors, without regard to whether that
product actually sold through to end-users. Internal corporate
documents and a former Cholestech employee reveal that the true
"installed base" at the time of the April 30 article was
approximately 7,500 Analyzers, not 10,000. Defendants also
knew or recklessly disregarded that the Company's reported
earnings were materially overstated due to the defendants'
strategy to "stuff the distribution channel" with excess
products and book all such "deliveries" as revenue and
earnings, despite knowing or recklessly disregarding that end-
users did not want the product. Pinckert further knew the
Company's installed base was not supporting product already in
the channel. His "prediction" of an "installed base" of 13,000
by the end of 1998, therefore, lacked a reasonable basis.
Defendants engaged in this plan in order to convey Cholestech
to the investment community as a growing, thriving business in
order to artificially inflate the price of Cholestech's stock
and to effectuate a secondary offering.
111. On May 15, 1998, Genesis analyst Tihansky issued a
research report on Cholestech and reiterated his "BUY"
recommendation and 12-month price target of $23 for the stock.
In this research report, in which Tihansky cited information
which could only have come from defendants, Tihansky stated
that "the installed base of LDX Analyzers now stands at
approximately 9,500 units, up from 5,000 in the prior year."
Tihanksy also addressed potential distribution problems that
Cholestech may be experiencing by quoting Cholestech directly.
Tihanksy wrote:
Management continues to believe that distribution
capabilities in the POL and Pharmacy markets
represent the greatest barriers to near-term growth.
Cholestech expects to resolve the shortcomings of
its distribution agreement with Amerisource, and it
continues to seek expanded distribution partnerships
in both the POL and pharmacy markets.
112. The statements attributed to Cholestech management
by Genesis analyst Tihansky were false and materially
misleading because defendants were "stuffing the channel" and
overstating revenues, income and market penetration and market
success of the LDX System. In fact, Cholestech (through
Tihansky) had no reasonable basis for making estimates about
the installed base of end-users because the Company only
estimated the number of "installed" Analyzers from the number
shipped to distributors, without regard to whether product was
selling through to end users. These issues would be revealed
to Cholestech shareholders only five weeks later when
defendants would finally reveal the effect of their channel-
stuffing activities throughout the Class Period. The
ramifications of such "channel stuffing" would affect
Cholestech's sales and earnings for months to follow the
Company's subsequent disclosures on June 25, 1998.
113. Upon information and belief, sometime during June,
1998, Cholestech engaged in a last-ditch effort to continue the
illusion that the Company's revenues and earnings were growing
and that the LDX System was meeting with market acceptance.
Based on information provided by someone with knowledge of
Cholestech's operations, Cholestech forced, or attempted to
force, at least two of its Health Promotion distributors to
take half a million dollars worth of Cholestech Systems to help
the Company make earnings and revenue estimates for its quarter
ending in June 1998 and to help Cholestech consummate its
announced secondary offering. The two distributors, Health
Management Systems and another distributor, were offered
additional merchandise from Cholestech if they would each
accept $250,000 of Cholestech's products immediately. Despite
Health Management Systems' pleas to Cholestech that it could
not sell such a large amount of merchandise, Cholestech
insisted on the "sale." Eventually, Health Management Systems
returned $40,000 worth of cassettes to Cholestech in exchange
for other Cholestech product. Cholestech accepted the returned
cassettes despite federal regulations which forbid such
activity.
Cholestech Stuns the Market by Previewing
Financial Results for Q1'99
114. On June 25, 1998, after trading closed for the day,
and just when the investment community expected Cholestech to
consummate its previously announced secondary offering, the
Company announced:
CHOLESTECH PREVIEWS FIRST QUARTER FISCAL 1999 RESULTS
HAYWARD, Calif.--(BUSINESS WIRE)-- June 25, 1998 --
Cholestech Corp. (NASDAQ:CTEC) today announced that
the delay of certain key distribution relationships,
as well as slower than expected distributor sales in
the United States, will result in a revenue shortfall
from expectations in the current fiscal quarter
ending June 26, 1998.
The company anticipates that current quarter revenues
will be between $4.9 million and $5.0 million, with
revenue growth of 15% to 25% over the previous year,
and down sequentially from the previous quarter ended
March 26, 1998. Revenues in the quarters ended June
27, 1997, and March 26, 1998, were $4.2 million and
$6.4 million respectively.
'Due to the anticipated revenue shortfall, the
company believes that the prudent course of action is
to cancel the proposed stock offering announced April
29, 1998,' said Andrea J. Tiller, Chief Financial
Officer.
'The financial impact to Cholestech of the canceled
public offering is a one-time, non-recurring charge
of approximately $500,000, or $(0.04) per share
(diluted), which will be recorded in the quarter
ending June 26, 1998.'
115. The reaction of the financial market to the
defendants' revelation of their fraud was swift and decisive.
On June 26, 1998, the next day of trading, Cholestech's shares
plunged to $6 per share from $11.75 per share, and a Class
Period high of $17.875, on extremely heavy volume of over two
million shares. Cholestech's shares presently trade at
approximately $2-$3 per share.
116. Although the Company reported revenue of $4.7 million
for Q1'99, approximately 6% or $287,000 of the reported revenue
was attributed to "deals." Furthermore, internal Cholestech
documents revealed that Cholestech sold a total of 471
Analyzers in this quarter, of which 250 Analyzers or 53% were
the result of "deals." The Company attributed the "revenue
shortfall" in this quarter to two factors: (1) "slower than
expected distributor sales," and (2) "the delay of certain key
distribution relationships." In fact, distributors expressly
told the Company that they could not sell all of the inventory
which they were coerced into purchasing, either by "deals" or
by other means.
117. Also on June 26, 1998, Sutro & Co. downgraded its
recommendation for Cholestech's stock to "sell" from "buy" on
Cholestech's announcement of lower than expected revenues.
118. On June 30, 1998, The Red Chip Review issued a
research report on Cholestech, expanding on the Company's June
25, 1998 press release. Upon information and belief, the
source of the information reported by The Red Chip Review was
Cholestech insiders. Under the headline, "Current Status:
Growing Pains" analyst Thomas wrote: "[e]nding a string of
record quarters, [Cholestech] announced that results for 1Q99
would fall below expectations. The softness stems from slower-
than-expected distributor sales in the United States and the
delay of certain key distribution relationships."
119. Red Chip analyst Thomas further wrote with regard to
Cholestech's planned secondary offering, inter alia:
In late April, [Cholestech] announced an offering of
3 million shares (not including over-allotment) of
common stock with Prudential Securities Incorporated
acting as the lead manager, and Vector Securities
International, Inc. and EVEREN Securities, Inc.
acting as co-managers in the offering. As a result
of the anticipated revenue shortfall, however, the
Company has now postponed the offering.
120. On July 22, 1998, Cholestech disclosed that despite
the disclosure only a month earlier that the Company would
report horrendous results and that Pinckert had engaged in a
scheme to artificially inflate Cholestech's revenues, earnings
and stock price, Pinckert was granted 40,000 stock options
under the 1997 Stock Incentive Plan.
Cholestech Announces Q1'99 Financial Results
121. Finally, on July 29, 1998, Cholestech announced its
results for the fiscal quarter ended June 29, 1998. The
Company reported revenues of $4.7 million for the first quarter
of 1999, which was down approximately 25% from the prior
quarter in which the Company announced a record $6.4 million in
revenue. As stated by defendant Pinckert:
Revenue of the first quarter was affected by
customers buying large quantities of Cholestech
[LDX's] in the March quarter in anticipation of an
April price increase, by a delay in the launch of an
international pharmaceutical program, and by delay in
obtaining distribution into the pharmacy market....
122. However, according to notes of a management meeting
that took place after the end of fiscal 1998, defendants
represented internally that the Company had a "run rate" of $28
million per year; that is, steady repeat business based on the
"installed base" of LDX Analyzers. This run-rate was based,
however, on an installed base of 10,000 Analyzers. The true
number was far below that, and the Company's run-rate in 1998
was, in reality, only approximately $18 million. Defendants
knew or recklessly disregarded throughout the Class Period that
Cholestech was basing its publicly disseminated estimate of
installed base on the number of Analyzers shipped to
distributors and that defendants had no idea how many Analyzers
actually sold through to end-users.
123. Sometime during Q4'98, defendants indicated to
Cholestech's distributors and customers that in Q1'99, the
Company would raise the price of its LDX Analyzer and the
accompanying cassettes. With defendants' tacit approval and/or
knowledge, Cholestech's customers reportedly began purchasing
very large quantities of the LDX Analyzers and cassettes
purportedly in order to stock up before the price increase.
The price "increase" for the LDX System, however, was part of
defendants' scheme to artificially stimulate additional short-
term demand for Cholestech's flagship product just in time for
the Company's proposed secondary offering of over three million
shares.
124. Cholestech's public announcement that the Company
would raise its price for the LDX System in Q1'99 was
materially misleading. Cholestech used this announcement as an
excuse for "stuffing the channels" in Q4'98, in a year-end
attempt to boost revenue. According to internal Cholestech
documents, the Company significantly decreased the average
price per unit for the LDX machine in Q4'98 to $848.15. This
is 19.13% lower than the Q3'98 average price of $1,048.77 per
unit.
125. On September 29, 1998, The Red Chip Review
disseminated another research report on Cholestech analyzing
the Company's fiscal first quarter 1999 results. Under the
heading "What Happened?," analyst Thomas wrote:
A number of issues contributed to the shortfall
during 1Q98 [sic], but most had to do with
distribution. [Cholestech] raised the price of its
instruments and, as anticipated, experienced strong
demand in advance of the new prices. Typical of many
fast-growing small companies, [Cholestech] lost track
of its inventory in the distribution channel. As the
Company rolled into the second quarter, demand
softened for the LDX unit. To remedy the situation,
the Company has put into place better tracking
measures to help determine its channel inventory.
Cholestech's Continued Decline
126. On December 21, 1998, The Red Chip Review announced
that it was dropping coverage of Cholestech. Describing its
reasons for dropping coverage of Cholestech, analyst Matthew
Desmond stated:
For one, the Company overestimated the development of
the pharmaceutical sector of its market. The sector
hasn't yet become what [Cholestech] had planned for.
Furthermore, [Cholestech] has apparently flooded its
distribution channels with product. If true,
upcoming periods will feel pressure as the
distributors draw down their inventories. Finally,
[Cholestech] had to withdraw its proposed secondary
offering when the low distributor sell-through issue
came to light and caused the stock to collapse. The
problem is that [Cholestech] needed the funds to
fully implement its growth strategy which included
stepping up [research and development expenses] for a
stronger new-product pipeline and more aggressive
growth.
127. On January 27, 1999, six months after the close of
the Class Period, Cholestech admitted that its sales were still
suffering from bloated inventories caused by the Company's
"channel stuffing" throughout the Class Period, and that sales
would continue to suffer for at least the "next few quarters"
of 1999. In a press release reporting Cholestech's financial
results, defendant Pinckert stated, inter alia: "We expect to
continue to reduce our inventory levels over the next few
quarters as the programs [to increase the Company's gross
margin] take effect."
128. Cholestech, prior, during and subsequent to
originally reporting its revenues and profits during the Class
Period, knew or recklessly disregarded that the "sales"
reported were materially misstated in that the channel was
bloated with at least a year's worth of unwanted product, that
defendants' disclosures did not present fairly the Company's
financial position, and that the disclosures made were not
adequate to make the information presented, not materially
misleading.
CHOLESTECH'S FALSE FINANCIAL REPORTS
129. In order to inflate the price of Cholestech's stock,
defendants caused the Company to falsely report its financial
results throughout the Class Period. Defendants did this by
improperly recognizing revenue on shipments to the Company's
distributors and by failing to adequately account for obsolete
inventory, which led to the a material overstatement of its
revenue, net income and earnings per-share for the Company's
financial reporting during the Class Period. Ultimately,
Cholestech admitted that its results for the fourth fiscal
quarter of fiscal 1998 would be adversely affected due to
excess inventory in the distribution channel. The Company's
channel stuffing affected the Company's revenues and earnings
for several quarters in the Company's fiscal 1998 year and
caused the Company to cancel its proposed 1998 secondary
offering.
130. By reporting financial results which were materially
overstated (i.e., with sequential revenue and earnings per
share gains), Cholestech was able to meet its own and analysts'
forecasts for revenue and earnings growth.
131. Cholestech's financial statements from the first
fiscal quarter of 1996 through the fourth fiscal quarter of
1998 were included in Form 10Q's & 10K's filed with the SEC.
The quarterly and annual SEC filings, signed by defendant
Pinckert, represented that the accompanying financial
statements included all adjustments "necessary for a fair
presentation of the financial condition and results for the
interim periods."
132. These representations were false and materially
misleading when made, as Cholestech's financial statements for
the first fiscal quarter of 1996 through the fourth fiscal
quarter of 1998 were not a "fair presentation" of Cholestech's
results and were in fact presented in violation of GAAP and SEC
rules.
133. GAAP are those principles recognized by the
accounting profession as the conventions, rules and procedures
necessary to define accepted accounting practice at a
particular time. SEC Regulation S-X (17 C.F.R. §210.4-
01(a)(1)) states the financial statements filed with the SEC
which are not prepared in compliance with GAAP are presumed to
be misleading and inaccurate, even despite footnote or other
disclosure. Regulation S-X requires that interim financial
statements must also comply with GAAP, with the exception that
interim financial statements need not include disclosures which
would be duplicative of disclosures accompanying annual
financial statements. 17 C.F.R. §210.10-01(a).
134. Defendants caused Cholestech to falsify its reported
financial results through improper revenue recognition on
Cholestech's shipments of product to distributors while
frequently granting to distributors explicit and implicit
rights to return unsold product. Pursuant to GAAP, moreover,
Cholestech should have deferred recognition of revenue on such
shipments, but did not in order to inflate its reported
results. Moreover, pursuant to GAAP, Cholestech was required
to adequately accrue losses for uncollectible accounts
receivable, but did not in order to report growing sales,
revenues and market acceptance during the Class Period.
135. GAAP, as set forth by Financial Accounting Standards
Board ("FASB") Statement of Accounting Standard ("SFAS") No.
48, Revenue Recognition When Right of Return Exists, prohibits
the recognition of revenue when the right of return exists
unless certain conditions are met. SFAS No. 48 applies to
transactions "in which a product may be returned, whether as a
matter of contract or as a matter of existing practice." SFAS
No. 48, ¶3. SFAS No. 48, ¶6 states:
If an enterprise sells its product but gives the
buyer the right to return the product, revenue from
the sales transaction shall be recognized at time of
sale only if all the following conditions are met:
a. The seller's price to the buyer is
substantially fixed or determinable at the date of
sale.
b. The buyer paid the seller, or the buyer is
obligated to pay the seller and the obligation is not
contingent on resale of the product.
c. The buyer's obligation to the seller would not
be changed in the event of theft or physical destruction
or damage of the product.
d. The buyer acquiring the product for resale has
economic substance apart from that provided by the seller.
(Emphasis in original.)
136. GAAP, as set forth in SFAS No. 5, Accounting for
Contingencies, requires that the estimated portion of
uncollectible accounts receivable be accrued in the period it
becomes evident that receivables or some portion of the
receivables will not be collected. SFAS No. 5, ¶22 states in
part:
Losses from uncollectible receivables shall be
accrued when [it is probable that an asset has been
impaired and the amount of loss can be reasonable
estimated]. Those conditions may be considered in
relation to individual receivables or in relation to
groups of similar types of receivables. If the
conditions are met, accrual shall be made even though
the particular receivables that are uncollectible may
not be identifiable.
137. Despite frequently granting an unfettered right to
return unsold merchandise to its distributors, Cholestech
improperly recognized revenue and failed to adequately accrue
losses for uncollectible receivables in order to inflate its
reported results, contrary to GAAP, and thus, SEC rules
138. Unfortunately for the investing public, Cholestech's
reported business results, and the representations concerning
them were false. Absent the Company's improper accounting for
revenues and receivables, Cholestech would have reported
materially lower earnings & revenues during the Class Period.
139. Ultimately, Cholestech disclosed that its first
quarter fiscal 1999 results would be adversely affected by
lower than expected sell-through of inventory in the channel
(and that such channel stuffing would adversely affect results
throughout Fiscal 1999) and that the Company would have to
cancel its proposed 1998 secondary offering.
140. Due to the accounting improprieties alleged herein,
Cholestech presented its financial results and statements in a
manner which violated GAAP, including the following fundamental
accounting principles:
(a) The principle that interim financial reporting
should be based upon the same accounting principles and
practices used to prepare annual financial statements (APB No.
28, ¶12);
(b) The principle that financial reporting should
provide information that is useful to present and potential
investors and creditors and other users in making rational
investment, credit and similar decisions was violated (FASB
Statement of Concepts No. 1, ¶34);
(c) The principle that financial reporting should
provide information about the economic resources of an
enterprise, the claims to those resources, and effects of
transaction, events and circumstances that change resources and
claims to those resources was violated (FASB Statement of
Concepts No. 1, ¶40);
(d) The principle that financial reporting should
provide information about how management of an enterprise has
discharged its stewardship responsibility to owners
(stockholders) for the use of enterprise resources entrusted to
it was violated. To the extent that management offers
securities of the enterprise to the public, it voluntarily
accepts wider responsibilities for accountability to
prospective investors and to the public in general (FASB
Statement of Concepts No. 1, ¶50);
(e) The principle that financial reporting should
provide information about an enterprise's financial performance
during a period was violated. Investors and creditors often
used information about the past to help in assessing the
prospects of an enterprise. Thus, although investment and
credit decisions reflect investors' expectations about future
enterprise performance, those expectations are commonly based
at least partly on evaluations of past enterprise performances
(FASB Statement of Concepts No. 1, ¶42);
(f) The principle that financial reporting should be
reliable in that it represents what it purports to represent
was violated. That information should be reliable as well as
relevant is a notion that is central to accounting (FASB
Statement of Concepts No. 2, ¶¶58-59);
(g) The principle of completeness, which means that
nothing is left out of the information that may be necessary to
insure that it validly represents underlying events and
conditions, was violated (FASB Statement of Concepts No. 2,
¶79); and
(h) The principle that conservatism be used as a
prudent reaction to uncertainty to try to ensure the
uncertainties and risks inherent in business situations are
adequately considered was violated. The best way to avoid
injury to investors is to try to ensure that what is reported
represents what it purports to represent (FASB Statement of
Concepts No. 2, ¶¶95, 97).
141. Further, the undisclosed adverse information
concealed by defendants during the Class Period was the type of
information which, because of SEC regulations, regulations of
the national stock exchanges and customary business practice,
is expected by investors and securities analysts to be
disclosed and is known by corporate officials and their legal
and financial advisors to be the type of information which is
expected to be and must be disclosed.
DEFENDANTS' SCIENTER
Defendants' Motive and Opportunity
142. Starting at least as early as June 1996 (the date of
Cholestech's secondary offering of $13 million of Cholestech's
shares) defendants crafted a plan to artificially inflate and
support Cholestech's stock price. Both Pinckert and Cholestech
were motivated to undertake their wrongful conduct for several
reasons.
143. Foremost, the defendants wanted to artificially
inflate the price of Cholestech's shares in order to present
the Company's finances and prospects in a false positive light
to ensure the success of their $13 million June 1996 secondary
offering, create demand for Cholestech's shares so that the
Company could tap the public markets for additional capital in
the near future, and attempt to consummate a 1997 secondary
stock offering of at least three million shares worth
approximately $40 million for the Company.
144. In addition, both Pinckert and Cholestech were
motivated to artificially boost the price of Cholestech's
shares in order to allow Cholestech insiders to sell almost
200,000 shares of Cholestech shares at artificially-inflated
prices and reap well over $2 million in ill-gotten gains for
themselves.
145. Defendants were additionally motivated to engage in
the fraud set forth herein to allow Company insiders to benefit
by defendants' manipulation of Cholestech's stock incentive
programs. Specifically, at Cholestech's Annual Meeting of
Shareholders on August 22, 1996 -- just after the beginning of
the Class Period and Cholestech's June 1996 secondary offering
-- defendants under the direction of defendant Pinckert,
amended the Company's 1988 Stock Incentive Program so that the
aggregate number of shares of stock authorized for issuance to
Company insiders was increased by 500,000 shares. This
increase was twice that of the previous amendment to the 1988
Program in 1995. Under the 1996 amendment to the 1988 Program,
defendant Pinckert received more stock options than any other
employee of the Company.
146. In fact, during fiscal 1997, Pinckert was granted
115,000 options to purchase Cholestech shares at only $4.50 per
share. By contrast, on July 21, 1997, the time of Cholestech's
original disclosures about this excessive grant of stock
options by Pinckert, Cholestech's shares were trading at $6.875
per share. This huge grant represented a stunning increase
from the grant of only 10,000 stock options awarded to him by
the Company in 1996 and is further evidence of his scienter.
Defendants engaged in the foregoing scheme at the outset of the
Class Period in order to set in motion a plan to enrich
themselves by granting themselves huge amounts of low-priced
stock options. Indeed, throughout the Class Period, defendants
and other Cholestech insiders exercised these options and
simultaneously sold the Cholestech shares received from the
options exercise to the investing public at artificially
inflated prices.
147. The 1996 amendment to the 1988 Program was not,
however, the only over-reaching "grab" by defendants to take
advantage of their manipulation of Cholestech's share price.
As defendants' fraud entered its second year, Pinckert and
other insiders dipped again into the Company's Stock Incentive
Program to unjustly enrich themselves. On August 22, 1997,
Cholestech held its Annual Meeting of Shareholders and adopted
the 1997 Stock Incentive Program. The 1997 Program was adopted
because the 1988 Program (as amended) was scheduled to expire
in February, 1998. The new program authorized reservation of
900,000 shares of Cholestech stock for issuance to Company
insiders.
148. This huge number of shares for Pinckert and his
cronies represented over 3-1/2 times the number of shares
reserved under the 1995 amendment to the 1988 Program and
almost double the number of shares reserved only a year earlier
under the 1996 amendment to the 1988 Program. In fact, during
fiscal 1998, defendant Pinckert received more stock options
than any other employee of the Company (40,000 stock options to
Pinckert alone for the year ended March 27, 1998). The Company
implemented its amendment to the 1988 Program just at the
outset of the Class Period and enacted the 1997 Program just
prior to the proposed 1997 secondary offering: Both actions
were part and parcel of defendants' fraudulent scheme.
Defendants' Insider Trading
149. In addition to the allegations above which
demonstrate Cholestech's and Pinckert's motive, certain
additional facts further demonstrate defendants' scienter. For
example, Pinckert's and other Cholestech insiders' selling of
shares is highly probative of their scienter and is part of
their scheme. As set forth herein, while Cholestech and
Pinckert issued materially false favorable statements about the
Company's business and concealing or obscuring negative
information, Pinckert and other Cholestech insiders who had
access to confidential information and were aware of the truth
about the Company and its operations, were benefiting from the
illegal course of business or course of conduct described in
this amended complaint by selling the Company's common stock at
artificially inflated prices without disclosing the material
adverse facts about the Company to which they were privy. Such
sales were unusual in their amount and in their timing.
Notably, Pinckert and many of the other top executives at
Cholestech sold Cholestech shares in the first few months of
1998, just a few months prior to the June 1998 adverse
announcement by Cholestech. The total of these 1998 sales
alone was over $1 million dollars. Importantly, Pinckert's
sale of 25,000 shares during the Class Period represented 25%
of his total shareholdings in Cholestech. The following table
shows the insider selling by Pinckert and other Cholestech
insiders during the Class Period:
______________________________________________________________
| | | | |
| Cholestech Insider | Sale Date | # of Shares | Proceeds |
|____________________|____________|_____________|______________|
| | | | |
| Warren E. Pinckert | 10/31/97 | 20,000 | $280,000 |
|____________________|____________|_____________|______________|
| | | | |
| | 02/02/98 | 5,000 | $60,950 |
|____________________|____________|_____________|______________|
| | | | |
| Steven Barbato | 6/11-13/97 | 5,000 | $29,050 |
|____________________|____________|_____________|______________|
| | | | |
| | 08/18/97 | 15,000 | $100,800 |
|____________________|____________|_____________|______________|
| | | | |
| | 09/12/97 | 5,000 | $52,200 |
|____________________|____________|_____________|______________|
| | | | |
| Gary E. Hewitt | 11/06/96 | 25,000 | $143,750 |
|____________________|____________|_____________|______________|
| | | | |
| | 09/04/97 | 20,000 | $167,600 |
|____________________|____________|_____________|______________|
| | | | |
| | 11/06/97 | 10,000 | $135,300 |
|____________________|____________|_____________|______________|
| | | | |
| | 2/20-23/97 | 10,000 | $137,000 |
|____________________|____________|_____________|______________|
| | | | |
| H.R. Sheperd | 11/04/97 | 6,000 | $79,500 |
|____________________|____________|_____________|______________|
| | | | |
| | 01/30/98 | 20,000 | $262,600 |
|____________________|____________|_____________|______________|
| | | | |
| | 03/06/98 | 15,000 | $200,550 |
|____________________|____________|_____________|______________|
| | | | |
| Joseph Buchman | 10/31/97 | 5,000 | $68,150 |
|____________________|____________|_____________|______________|
| | | | |
| | 11/04/97 | 1,200 | $16,008 |
|____________________|____________|_____________|______________|
| | | | |
| | 01/30/98 | 7,000 | $91,910 |
|____________________|____________|_____________|______________|
| | | | |
| Harvey S. Sadow | 11/18/97 | 5,000 | $70,000 |
|____________________|____________|_____________|______________|
| | | | |
| | 02/18/98 | 10,000 | $130,000 |
|____________________|____________|_____________|______________|
| | | | |
| John L. Castella | 2/19-20/98 | 12,500 | $172,000 |
|____________________|____________|_____________|______________|
| | | | |
| TOTAL | n/a | 196,700 | $2,197,368 |
|____________________|____________|_____________|______________|
INAPPLICABILITY OF STATUTORY SAFE HARBOR
150. The statutory safe harbor that applies to forward-
looking statements under certain circumstances does not apply
to any of the allegedly false statements pleaded herein. The
statements alleged to be false and materially misleading relate
to then-existing facts and conditions. In addition, to the
extent certain of the statements alleged to be false may be
characterized as forward-looking, they were not identified as
"forward-looking statements" when made, there was no statement
made with respect to any of those representations forming the
basis of this Complaint that actual results "could differ
materially from those projected," and there were no meaningful
cautionary statements identifying important factors that could
cause actual results to differ materially from those in the
purportedly forward-looking statements. Alternatively, to the
extent that the statutory safe harbor does apply to any
forward-looking statements pleaded herein, defendants are
liable for those false forward-looking statements because at
the time each of those forward-looking statements was made, the
particular speaker had actual knowledge that the particular
forward-looking statement was false, and/or the forward-looking
statement was authorized and/or approved by an executive
officer of Cholestech who knew that those statements were false
when made.
COUNT I
FOR VIOLATION OF THE SECURITIES EXCHANGE ACT
OF 1934 AND RULE 10b-5 PROMULGATED THEREUNDER
[Against All Defendants]
151. Plaintiffs incorporate by reference all of the
preceding paragraphs as if set forth fully herein.
152. This action is based upon the provisions of Section
10(b) of the Exchange Act, and Rule 10b-5 promulgated
thereunder for the materially false and misleading statements
and omissions in the statements and documents referred to
herein.
153. Defendants knew or recklessly disregarded the fact
that the aforesaid acts and practices, materially misleading
statements and omissions would adversely affect the integrity
of the market for Cholestech common stock and would
artificially inflate or maintain the price of such stock.
154. By reason of the foregoing, defendants have violated
violations of Section 10(b) of the Exchange Act and Rule 10b-5
promulgated thereunder, in that they:
(a) Employed devices, schemes and artifices to
defraud;
(b) Made untrue statements of material facts or
omitted to state material facts necessary in order to make the
statements made, in light of the circumstance under which they
were made, not misleading; or
(c) Engaged in acts, practices and a course of
business which operated as a fraud or deceit upon plaintiffs
and other members of the Class in connection with their
transactions in Cholestech common stock during the Class
Period.
155. As a result of the foregoing, the market price of
Cholestech common stock was artificially inflated during the
Class Period. In ignorance of the materially false and
misleading nature of the representations and omissions
described above, plaintiffs and other members of the Class
relied, to their damage in purchasing Cholestech common stock,
on the aforesaid materially misleading statements described
herein and/or the integrity of the market.
156. The price of Cholestech common stock declined
materially following the public disclosure of the true facts
which had been misrepresented or concealed as alleged in this
Complaint. Plaintiffs and other members of the Class have
suffered substantial damages as a result of the wrongs herein
alleged.
COUNT II
FOR VIOLATION OF SECTION 20(a) OF THE EXCHANGE ACT
[Against Defendant Pinckert]
157. Plaintiffs incorporate by reference all of the
preceding paragraphs as if set forth fully herein.
158. Defendant Pinckert acted as a controlling person of
the Company within the meaning of Section 20(a) of the Exchange
Act. By reason of his position as a senior officer and/or
director, as alleged above, this defendant had the power and
authority to cause the Company to engage in the wrongful
conduct complained of herein.
159. By reason of such wrongful conduct, defendant
Pinckert is liable pursuant to Section 20(a) of the Exchange
Act. As a direct and proximate result of the defendants'
wrongful conduct, plaintiffs and the other members of the Class
suffered damages in connection with their purchases of the
Company's securities during the Class Period.
PRAYER
WHEREFORE, plaintiffs on their own behalf, and on behalf
of the other members of the Class, pray for judgment as
follows:
(a) Declaring this action to be a proper class
action, certifying plaintiffs as Class representatives and
their counsel as Class counsel;
(b) Declaring and determining that defendants
violated the federal securities laws by reason of their conduct
as alleged herein;
(c) Awarding money damages against defendants in
favor of plaintiffs and the Class for all losses and injuries
suffered as a result of the acts and transactions complained of
herein, together with pre-judgment interest on all of the
aforesaid damages which the Court shall award from the date of
said wrongs to the date of judgment herein at a rate the Court
shall fix;
(d) Awarding plaintiffs their costs and expenses
incurred in this action, including reasonable attorneys',
accountants' and experts' fees; and
(e) Awarding plaintiffs such other relief as may be
just and proper.
Dated: June 24, 1999 LAW OFFICES OF LIONEL Z. GLANCY
_______________________________
Lionel Z. Glancy
Tracy L. Thrower
Michael Goldberg
1801 Avenue of the Stars #311
Los Angeles, California 90067
Phone: (310) 201-9150
Fax: (310) 201-9160
Lead Counsel for Plaintiffs
ROBERT C. SUSSER, P.C.
Robert C. Susser
6 East 43rd Street
Suite 1900
New York, New York 10017-4609
Phone: (212) 808-0298
Fax: (212) 949-0966
LAW OFFICES OF BRIAN BARRY
Brian Barry
8424-A Santa Monica Boulevard
PBM #184
Los Angeles, California 90069
Phone: (323) 954-7210
Fax: (323) 954-7235
Attorneys for Plaintiffs
JURY DEMAND
Plaintiffs hereby demand a trial by jury.
Dated: June 24, 1999 LAW OFFICES OF LIONEL Z. GLANCY
_______________________________
Lionel Z. Glancy
Tracy L. Thrower
Michael Goldberg
1801 Avenue of the Stars #311
Los Angeles, California 90067
Phone: (310) 201-9150
Fax: (310) 201-9160
Lead Counsel For Plaintiffs
ROBERT C. SUSSER, P.C.
Robert C. Susser
6 East 43rd Street
Suite 1900
New York, New York 10017-4609
Phone: (212) 808-0298
Fax: (212) 949-0966