Red Hat: Perpetrator or Victim?

By Dennis E.
Powell for LinuxToday

What did Bob Young know, and when did he know it?

That’s the crucial question for the biggest commercial Linux
distributor in a class-action complaint filed Tuesday in U.S.
District Court for the Southern District of New York against Red
Hat, Inc., and two of the underwriters of its initial public stock
offering. It joined a suit filed four days earlier.

The lawsuit alleges that the underwriters, Goldman Sachs &
Co., and Credit Suisse First Boston, illegally manipulated the
price of Red Hat shares, demanded kickbacks in exchange for
participation in the IPO, and otherwise defrauded investors seeking
to get in on what was believed to be one of the hottest stock
offerings of 1999.

It further claims that Red Hat is liable because its prospectus
failed to mention the kickbacks and manipulation. Named
individually as defendants are Red Hat Chairman and CEO Robert F.
Young, President and Matthew J. Szulik, and Executive Vice
President and Chief Operating Officer Marc Ewing. The suit is
brought by the New York firm Milberg Weiss Bershad Hynes &
Lerach LLP in behalf of investors who purchased a stake in Red Hat
between the IPO date, August 11, 1999, and May 25, 2000. The firm
specializes in class-action litigation. A number of other firms are
listed as plaintiff’s lawyers in the complaint.

While Red Hat and its officers are defendants in the action, the
23-page complaint clearly targets the underwriters, and counts on
the matter of law that Young and the others are legally liable for
the underwriters’ actions. The complaint does not allege that Red
Hat or its officers participated in fraudulent action beyond
signing their names to a prospectus that later, the suit claims,
turned out to be untrue due to the underwriters’ crooked
behavior.

If it is determined at trial that Red Hat knew about and
acquiesced to behavior shown to be illegal, that could of course
change.

Red Hat’s response was terse, and offered no defense of the
actions of the underwriters of the IPO.

“With respect to Red Hat and its officers and directors, we
think the claim has no merit,” said Red Hat spokeswoman Melissa
London. “We have no further comment at this time.”

The Milberg Weiss lawsuit comes just four days after a similar
action filed in the same court by Sirota & Sirota LLP and
Lovell & Stewart LLP, this one in behalf of shareholders
between the IPO date and March 19 of this year. That suit is
against Red Hat and its officers; though the allegations are
similar, the underwriters are not named as defendants.

It is not unusual for there to be multiple class-action
shareholder lawsuits, but they are typically filed soon after a
precipitous drop in share prices. The Milberg Weiss suit was not
filed until 10 months after the period during which the fraud is
alleged. That suit appears to rely heavily on published reports of
a federal Securities and Exchange Commission investigation into
improper handling of initial public offerings.

During the heady — some, including Federal Reserve Chairman
Alan Greenspan, would say “irrational” — days of the late 1990s,
IPO’s were as close to a sure thing as could be achieved in the
equities market, with huge first day “pops” in share prices. Those
who got in on IPO’s at the offering price were all but certain to
reap huge profits. Indeed, Red Hat shares almost quadrupled their
$14 offering price the first day. (Red Hat peaked at $264.50 on
January 7, 2000, and announced a 2:1 stock split three days later.
Its price at midday Wednesday was $4.39.)

Eagerness by investors to participate in IPOs led the
underwriters, who control which investors can buy at the IPO price
and which ones cannot, to cross the line and make illegal demands
on participants, according to the lawsuits. These are claimed to
include kickbacks to the underwriters, agreements by investors to
purchase shares in other companies, and even agreements to purchase
more shares in the IPO company later, to keep the stock price high.
In some cases it is alleged that the underwriters demanded
commissions that were a percentage of the profits enjoyed by
investors when the share prices rose.

The prospectus states that the commission would be an industry
standard 7 percent, and it is here that Red Hat’s exposure takes
place (though the company certainly would have benefited from
manipulation calculated to increase its share prices, there is no
explicit claim that the company actively participated in such
manipulation).

The Wall Street Journal has reported over several months that
the SEC was investigating one of Red Hat’s underwriters, CSFB, in
connection with improper IPO commissions. And there are numerous
stories in the investment community of participants in Goldman
Sachs-underwritten IPO’s agreeing not to dump their shares on the
market once the price climbs, which could be seen as a way of
manipulating share prices so as to keep them artificially high.

In its complaint, Milberg Weiss alleges that Red Hat and its
officers and directors were in control of Red Hat during the period
covered by the lawsuit. The truly damning allegations are against
the underwriters, of whom it is said that they:

— “Carried out a plan, scheme, and course of conduct which was
intended to and did . . . deceive the investing public . . .
artificially inflate and maintain the market price of Red Hat
common stock . . .”

— “Employed devices, schemes, and artifices to defraud . . .
made untrue statements of material fact and/or omitted to state
material facts necessary to make the statements not misleading . .
. and engaged in acts, practices, and a course of business which
operated as a fraud and deceit upon the purchasers of the Company’s
common stock . . .”

— “Engaged and participated in a continuous course of conduct
to conceal adverse material information about the Offering of Red
Hat common shares . . .”

— “Had actual knowledge of the misrepresentations and omissions
of material facts . . . or acted with reckless disregard for the
truth . . .”

— That the falsehood was designed to conceal that the
underwriters “received additional, excessive, and undisclosed
commissions . . . had arranged for customers to purchase Red Hat
shares in the after-market, which artificially inflated and
sustained the after-market price . . . [and] received undisclosed
commissions in the form of excessive commissions from customers in
connection with the purchase of other securities.”

In short, the lawsuits allege that Red Hat stock shot through
the roof because its value was artificially and illegally inflated,
rather than because of the actual value of the company itself.

The lawsuits seek damages that, if awarded, could be financially
crippling, perhaps fatal. These include restitution of money lost
by investors in Red Hat, even those who sold their stock during the
various periods covered by the different lawsuits.

Even if it is determined that neither Red Hat nor its officers
were engaged in any wrongdoing, legal costs for defense of the
multiple lawsuits are likely to be high. And ignorance of the
underwriters’ actions might not be a valid defense, because the
company and its officers certify in the offering prospectus that
the statements it contains are true. Should it come to pass that a
jury rules in favor of the plaintiffs, Red Hat might have recourse
in a separate action against the underwriters, but lawyers not
directly involved in the case said that this would depend on many
factors, none of which are known.