Lawsuits Brew over Red Hats Accounting Changes

Updated: In response to the Linux company's decision to alter its accounting methods, 10 law firms say they are preparing stockholder class-action lawsuits alleging that Red Hat manipulated its earnings.

Its being a long week for Red Hat executives, as no fewer than 10 law firms have announced their intentions to launch stockholder class-action lawsuits against the Raleigh, N.C., Linux company in the wake of its announcement that it is changing its accounting methods.

Typically, the complaints charge that Red Hat Inc. CEO and president Matthew Szulik, former chief financial officer Kevin Thompson and other company officers violated the Securities Exchange Act of 1934.

The complaints tend to allege that Red Hat failed to disclose or misrepresented facts that it knew or recklessly disregarded: that the company inappropriately recognized subscription revenues; that as a consequence, it manipulated its quarterly earnings so that its net income and operating income were materially overstated; that the companys financial results were in violation of Generally Accepted Accounting Principles (GAAP); that the company lacked adequate internal financial controls; and that its financial results were materially and artificially inflated.

Prompting the flurry of lawsuits was Red Hats unexpected announcement Tuesday that it was changing how it was recognizing revenues for its Linux subscription agreements. Because of the change, the company also announced that it would be restating its financial results for the past three fiscal years and its unaudited financial statements for the latest fiscal quarter.

The material change to Red Hats accounting was on the advice of its auditor, PricewaterhouseCoopers. It now recognizes revenues for subscription revenues on a daily basis instead of recognizing the revenue on the first day of the month in which a subscription contract began.

Coming on the heels of its CFOs resignation and concern over the timing of its first-quarter results and exactly when its auditors had requested that the company change its accounting methods, the stock market reacted badly to the news. By Thursday, the stocks price had dropped by more than 20 percent on extremely heavy trading.

Since then, the stock price, even in the face of a flood of potential lawsuit announcements, has started to rise on moderate trading.

Andrea Vachss, corporate and securities attorney in the San Francisco office of the international law firm Covington & Burling, commented that such shareholder actions were usual following such fiscal troubles.

"It is all but inevitable that, when a company announces that it will restate its financial results, a significant drop in the price of its stock and lawsuits on behalf of shareholders will follow," Vachss said. "Historically, recognition of revenue has been a difficult issue in the software industry, and the spate of restatements by companies in this space, including, most recently, Red Hat, appears to continue to reflect that."

As for Red Hat, company spokeswoman Leigh Day said, "As in any lawsuit, the company is prepared to defend itself. To my knowledge, no one has actually launched a suit at this time."

Editors Note: This story was updated to include comments from the Covington & Burling lawyer.


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