UNITED STATES DISTRICT COURT NORTHERN DISTRICT OF...

Case: 1:14-cv-00318 Document #: 43 Filed: 05/28/14 of 63 PageID #:479

UNITED STATES DISTRICT COURT NORTHERN DISTRICT OF ILLINOIS

FERNANDO ROSSY, Individually and on Behalf of All Others Similarly Situated,

Plaintiffs,

v.

MERGE HEALTHCARE, INC., MICHAEL W. FERRO, JR., JEFFERY A. SURGES, STEVEN M. ORESKOVICH and JUSTIN C. DEARBORN,

Defendants.

Civil Action No. 1:14-cv-0318

JURY TRIAL DEMANDED

CONSOLIDATED AMENDED COMPLAINT


TABLE OF CONTENTS

Page

INTRODUCTION .............................................................................................................. 1

NATURE OF THE ACTION ............................................................................................. 1

JURISDICTION AND VENUE ......................................................................................... 4

PARTIES............................................................................................................................ 4

A. Lead Plaintiff ...................................................................................................................... 4

B. Defendants .......................................................................................................................... 4

V. OVERVIEW AND SUMMARY OF DEFENDANTS' RECKLESS CONDUCT ............ 6

A. Merge Transitions To A Subscription-Based Pricing Model ............................................. 7

B. Subscription Revenue Backlog Becomes A Critical Metric For Analysts And Investors .. 9

C. The Company Reports Rapidly Increasing Subscription Revenue Backlog Figures During The Class Period Due To Purported Sales In Merge DNA’s eClinical Division ............. 11

D. Merge’s Reported Subscription Revenue Backlog Figures Were Recklessly Overstated 17

E. The Truth Begins To Emerge ........................................................................................... 21

F. Defendants Finally Confirm The Falsity Of Merge’s Subscription Revenue Backlog .... 24

VI. DEFENDANTS’ FALSE AND MISLEADING STATEMENTS ................................... 26

VII. LOSS CAUSATION ......................................................................................................... 47

VIII

THE FRAUD-ON-THE-MARKET DOCTRINE APPLIES ............................................ 50

IX. THE STATUTORY SAFE HARBOR IS INAPPLICABLE............................................ 51

X. CLASS ACTION ALLEGATIONS ................................................................................. 52

XI. CAUSESOF ACTION ..................................................................................................... 54

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I. INTRODUCTION

Lead Plaintiff Arkansas Teacher Retirement System (“Lead Plaintiff”) makes the

following allegations against defendants Merge Healthcare, Inc. (“Merge” or the “Company”),

Michael W. Ferro (“Ferro”), Jr., Jeffery A. Surges (“Surges”), Justin C. Dearborn (“Dearborn”),

and Steven M. Oreskovich (“Oreskovich”) (collectively, “Defendants”). 1 Except as to

allegations specifically pertaining to Lead Plaintiff and Lead Plaintiff’s counsel, the allegations

herein are based upon an investigation undertaken by Lead Plaintiff’s counsel, which included,

but was not limited to, the review and analysis of: (i) Merge’s public filings with the United

States Securities and Exchange Commission (“SEC”); (ii) securities analysts’ reports about

Merge; (iii) transcripts of Merge’s conference calls; (iv) Merge press releases; (v) media reports

concerning Merge; (vi) numerous interviews with former Merge employees; and (vii) websites

concerning Merge. Lead Plaintiff believes that additional evidentiary support will exist for the

allegations herein after Lead Plaintiff has had a reasonable opportunity to conduct discovery.

II. NATURE OF THE ACTION

1. This is a federal securities class action brought on behalf of all persons who

purchased Merge common stock between August 1, 2012 and January 7, 2014, inclusive (the

“Class Period”), and were damaged thereby (the “Class”), seeking remedies under Sections 10(b)

and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”), as amended by the Private

Securities Litigation Reform Act of 1995 (“PSLRA”) and Rule 10b-5 promulgated thereunder

(17 C.F.R. § 240.10b-5).

2. Merge is a healthcare information technology (“HCIT”) company that develops

enterprise imaging, interoperability, and clinical systems for providers and consumers in the

1 All emphasis is added unless otherwise noted.

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healthcare market, including software solutions designed to facilitate the sharing of medical

images, as well as clinical trials software with end-to-end study support in a single platform.

3. Prior to the start of the Class Period, on May 7, 2012, Merge announced the

creation of two operating groups: Merge Healthcare and Merge Data & Analytics (“Merge

DNA”). While Merge Healthcare develops, sells, and implements interoperability, imaging, and

clinical solutions to healthcare providers, Merge DNA focuses on consumer-focused solutions,

including, among others, a subscription-based clinical trials platform called eClinical OS

(“eCOS”). Merge stated that, effective in the second financial quarter of 2012, it would

separately report the respective results of each of these new segments in order to provide

enhanced transparency into the Company’s financial performance as it shifted from a perpetual

license agreement model toward a subscription-based revenue model.

4. In connection with this transition to a subscription-based pricing model, Merge

also introduced a new metric to the Company’s financial reports – subscription revenue backlog

– which, according to the Company, represents revenue from subscription-based contracts that

the Company anticipates recognizing in future periods. This metric became particularly

important to investors during the Class Period because it provided greater visibility and

transparency into Merge’s future revenue despite the near-term headwinds that the Company

faced in the initial stages of its transition.

5. During the Class Period, Defendants repeatedly touted the growth in the

Company’s subscription revenue backlog, indicated that the growth was due to new contracts

being signed in Merge DNA’s eClinical Division (“eClinical”), and praised the metric as a

reliable indicator of future revenue. Moreover, Defendants made numerous assurances as to the

adequacy of the Company’s internal controls.

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6. However, Defendants’ Class Period statements regarding the Company’s

subscription revenue backlog and internal controls were materially false and misleading because

Defendants recklessly overstated the size of Merge’s subscription revenue backlog. Indeed, due

to severe deficiencies in the Company’s internal controls, the subscription revenue backlog

figures that Defendants reported to the market had been artificially inflated by millions of dollars

during the Class Period.

7. Ultimately, on January 8, 2014, the Company shocked the market when it

disclosed severe deficiencies in its internal controls over its processes for logging customer

contracts and calculating commissions for its sales personnel, and revealed that by exploiting

these deficiencies, one of its sales employees was able to falsify the existence and/or amount of

millions of dollars in customer contracts in order to achieve sales quotas and receive additional

commissions. As a result, the Company announced that it was modifying its internal control

procedures and materially reducing Merge DNA’s previously-reported subscription revenue

backlog totals for each of the six quarterly periods ended June 30, 2012 through September 30,

2013 by a combined $15.1 million .

8. Defendants’ reckless overstatement of Merge’s reported subscription revenue

backlog caused the price of its common shares to be materially inflated during the Class Period.

As the market began to learn of Merge’s overstated subscription revenue backlog figures, the

Company’s share price declined, causing Lead Plaintiffs and the Class to suffer damages. For

instance, following Merge’s January 8, 2014 disclosure, the Company’s stock price declined by

more than 16%, from its closing price of $2.52 per share on January 7, 2014 to close at $2.11 per

share on January 9, 2014.

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III. JURISDICTION AND VENUE

9. Jurisdiction is conferred by § 27 of the Exchange Act. The claims asserted herein

arise under §§ 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder.

This Court has jurisdiction over the subject matter of this action under 28 U.S.C. § 1331 and § 27

of the Exchange Act.

10. Venue is proper in this District pursuant to § 27 of the Exchange Act and 28

U.S.C. § 1391(b), as the Company conducts business in this District and the Company’s stock

traded on the NASDAQ at all relevant times.

11. In connection with the acts alleged in this complaint, Defendants, directly or

indirectly, used the means and instrumentalities of interstate commerce, including, but not

limited to, the mails, interstate telephone communications, and the facilities of the national

securities markets.

IV. PARTIES

A. Lead Plaintiff

12. Lead Plaintiff Arkansas Teacher Retirement System (“ATRS”) is a public pension

fund established in 1937 for the benefit of the employees of Arkansas’ education community and

manages billions of dollars in assets. As reflected in its certification previously filed in this

action (ECF No. 12), ATRS purchased shares of Merge common stock on the NASDAQ during

the Class Period and suffered losses as a result of the conduct complained of herein.

B. Defendants

13. Defendant Merge is incorporated in Delaware and maintains its principal

executive offices in Chicago, Illinois. The Company offers healthcare software solutions,

including enterprise and cloud-based imaging solutions for providers, as well as clinical trials

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software and other health data and analytics solutions for consumers. Merge common stock is

traded on the NASDAQ under the symbol “MRGE.”

14. Defendant Ferro served as a director and the Chairman of Merge’s Board of

Directors until his resignation on August 26, 2013.

15. Defendant Surges served as a director and the Company’s Chief Executive

Officer (“CEO”) until his resignation on August 5, 2013.

16. Defendant Dearborn served as a director and the Company’s President at all

relevant times, and the CEO of Merge DNA until August 5, 2013, when he was appointed CEO

of the Company, effective August 8, 2013.

17. Defendant Oreskovich served as the Company’s Chief Financial Officer (“CFO”)

and Treasurer at all relevant times.

18. Defendants Ferro, Surges, Dearborn, and Oreskovich are referred to collectively

herein as the “Individual Defendants.”

19. The Individual Defendants are liable as direct participants with respect to the

conduct complained of herein. In addition, each of the Individual Defendants, by reason of his

status as a senior executive officer and/or director, was a “controlling person” within the

meaning of Section 20(a) of the Exchange Act, and had the power and influence to cause the

Company to engage in the unlawful conduct complained of herein. Because of their positions of

control, the Individual Defendants were able to and did, directly or indirectly, control the

conduct of Merge’s business.

20. Specifically, because of their positions within the Company, the Individual

Defendants controlled the contents of the Company’s public statements made during the Class

Period. The Individual Defendants were provided with, or had access to, copies of the

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documents alleged herein to be false and/or misleading prior to or shortly after their issuance,

and had the ability and opportunity to prevent their issuance or to cause them to be corrected.

21. Because of their positions and access to material non-public information, the

Individual Defendants recklessly disregarded that the adverse facts specified herein had not been

disclosed to, and were being concealed from, the public, and that the positive representations that

were being made were materially false and misleading. As a result, the Individual Defendants

are, and were, responsible for the accuracy of Merge’s corporate statements and are therefore

responsible and liable for the representations contained therein.

V. OVERVIEW AND SUMMARY OF DEFENDANTS’ RECKLESS CONDUCT

22. Throughout the Class Period, Defendants issued false and misleading statements

regarding Merge’s subscription revenue backlog with a reckless disregard for material

weaknesses in the Company’s processes for recording customer contracts and compensating

sales employees, which inevitably led to the false subscription revenue backlog numbers.

Specifically, as confirmed by numerous former employees with detailed knowledge of

Defendants’ conduct and the internal controls in place at the Company during the Class Period,

eClinical senior management was aware of, but failed to correct, critical flaws in its processes for

executing customer contracts and paying sales commissions based upon purported contract

signings. These material deficiencies allowed sales employees to receive sales commissions

whether or not the customer ever actually signed the contract and/or was invoiced for the

transaction. Moreover, on numerous occasions, Defendants and other senior management

instructed eClinical accounting personnel to disregard internal guidelines by recognizing revenue

and compensating sales employees based upon unverified and/or unfulfilled contract bookings.

23. By exploiting these material deficiencies in Merge’s internal controls, at least one

former sales employee was able to falsify the amount and/or existence of customer contracts by

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approximately $5.8 million in 2012 and $9.4 million in 2013. These falsified contract amounts

were included in the subscription revenue backlog figures that Merge reported to the market on a

quarterly basis, causing them to be materially overstated. Accordingly, Defendants acted

recklessly during the Class Period by: (i) materially misrepresenting Merge’s reported

subscription revenue backlog figures; (ii) disregarding that Merge lacked effective internal

controls to provide reasonable assurance concerning the reliability of its financial reporting,

specifically with respect to the subscription revenue backlog numbers; and (iii) making

representations to the market regarding the adequacy of Merge’s internal controls.

24. As a result of Defendants’ recklessness, Merge reported artificially-inflated

subscription revenue backlog amounts to the market throughout the Class Period, thereby

creating the false impression that the Company had a predictable stream of recurring revenue and

was poised for future profitability.

A. Merge Transitions To A Subscription-Based Pricing Model

25. Founded in 1987, Merge develops enterprise imaging and interoperability

solutions and services that are designed to optimize the maintenance and exchange of healthcare

data for hospitals, clinics and labs, medical device manufacturers, and major pharmaceutical

companies worldwide. Merge’s product portfolio includes software development toolkits,

technologies, and platforms; image interoperability platforms; hosted software solutions; and

clinical and financial information systems.

26. Prior to the start of the Class Period, Merge sold the majority of its product

offerings to customers through perpetual license agreements, under which, software, hardware,

and professional services are treated as sources of non-recurring revenue and backlog. However,

in the first quarter of 2012, Merge began to shift away from this traditional perpetual license

agreement model in favor of a subscription-based revenue model.

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27. On May 7, 2012, Merge issued a press release (the “May 7, 2012 Press Release”)

announcing the creation of two operating groups, Merge Healthcare and Merge DNA in

connection with the Company’s transition toward a subscription-based business model. Citing

increased client demand for subscription-based offerings, the May 7, 2012 Press Release stated

that this transition would “position the [C]ompany for growth and ensure greater transparency,

predictability and profitability.”

28. During the Company’s May 8, 2012 conference call with analysts and investors to

discuss its first-quarter 2012 financial results (the “May 8, 2012 Conference Call”), Defendant

Surges provided further detail regarding the Company’s transition toward a subscription-based

business model, and highlighted the fact that the transition would increase the predictability of

Merge’s revenues:

I’d like to start this call by talking about an exciting development we announced yesterday – the creation of two operating groups, Merge Healthcare and Merge DNA. I will operate Merge Healthcare, which will include all of our clinical solutions that serve the needs of hospitals, health systems, ambulatory settings and payers; think of this as 85% of our traditional businesses. Justin Dearborn will return to an operating role and lead Merge Data & Analytics, or Merge DNA, the other 15% of our business whose assets will include consumer health stations, clinical trial software, and other consumer-focused solutions. This change in operations is being driven by our clients’ purchasing requirements for subscription-based pricing to align more closely with their long-term operating plans. These two new operating groups are designed to allow for better focus on our two primary end users – providers and consumers. The organizational model will ensure that we maximize our transparency, our predictability, and ultimately our profitability.

It is our expectation that this new organizational structure will not only increase transparency and relieve any confusion for analysts, investors, and also our customers, but also – and more importantly – will provide Merge with the foundation to capitalize on the great opportunities we have before us. Starting with our Q2 results you will be able to see Merge Healthcare and Merge DNA’s financial performance separately. We have taken this step to provide a greater level of detail on our operating performance, our scale, our business strategy, and our execution.

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Transitioning to the subscription pricing model will accomplish three things for Merge – first, it will generate predictable stream of recurring revenue; second, it will position Merge for continued growth and success; and third, it will ultimately prove more profitable. Right now our immediate attention will be on securing this new model for predictable long-term growth. As one of the few providers in this space offering the subscription pricing model and with the response we’ve seen so far from our clients, we see tremendous opportunities in both the near and long term. I would like to reiterate that we expect our year-over-year revenue to grow . . . .

B. Subscription Revenue Backlog Becomes A Critical Metric For Analysts And Investors

29. While market participants uniformly believed that the transition to a subscription-

based pricing model would have a positive impact on the Company’s long-term prospects, they

remained concerned that it could cause short-term volatility in Merge’s revenues. For example,

on May 8, 2012, a William Blair analyst reported in pertinent part:

. . . [N]ear-term margins and revenue will be affected during the transition to [a subscription-based] model, as the typical bolus of high-margin perpetual license revenue (as well as lower-margin implementation revenue) is no longer recorded in a single period but rather amortized over a longer period.

. . . However, we actually like the move toward a more subscription-based model over the longer term, as we believe it could increase sales visibility as well as the lifetime value of a client. Moreover, HCIT vendors with larger subscription-based books of business typically see premium multiples, thus this change, while a near-term headwind to the financials (and likely the stock), could benefit Merge in the long run, in our view.

30. Similarly, on May 9, 2012, Craig-Hallum noted in pertinent part: “We anticipate

that this transition will be a tough one and will likely take at least a year to work through. . . .

That said, the transition to a subscription based model is a good long-term move in our view,”

because it would result in “a recurring revenue source, higher visibility, better margins, and

overall better EBITDA.”

31. Also on May 9, 2012, Dougherty & Company commented:

Subscription models generate lower revenue up front but have higher value

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longer-term and about 80% of Merge’s revenue is expected to be generated from subscription based solutions within the next two years. As the company transitions to the new model, we expect short-term volatility but predictable revenue stream and improved visibility in the long run.

32. Further, in a May 11, 2012 report, Imperial Capital stated in pertinent part:

In our view, these recent changes represent near-term pains for long-term gains. While we expect near-term growth to appear slower under the SaaS model than under the perpetual model as new contracts are recorded ratably over the life of the contract, we believe the long-term advantages to this model outweigh the near-term appearance of slowing growth.

33. Given the anticipated near-term volatility in Merge’s revenues that would

accompany its shift toward a subscription-based business model, investors were increasingly

focused on Merge’s long-term revenue prospects. As a result, it became especially important for

Merge to provide visibility into its expected future revenues in order to maintain the market’s

confidence in its long-term prospects. To this end, following its shift to a subscription-based

pricing model, the Company began reporting a new financial metric – subscription revenue

backlog – for each operating segment. The Company reported this metric to the market multiple

times each quarter during the Class Period – in press releases, on conference calls, and in its

quarterly reports filed with the SEC on Form 10-Q.

34. As defined by the Company, subscription revenue backlog is revenue from

subscription-based transactions, including software, hardware, and professional services

contracted with and payable by the customer over a number of years, that the Company

anticipates recognizing as revenue in future periods. In essence, according to the Company,

subscription revenue backlog represents revenue that the Company has not yet earned, but that

its customers have contractually agreed to pay to the Company in future periods.

35. Throughout the Class Period, Defendants characterized the Company’s

subscription revenue backlog as a “predictable” measure of future recurring revenue because

10


customers were contractually obligated to pay the Company for its products and services during

future periods. For instance, during Merge’s August 2, 2012 conference call with analysts and

investors to discuss the Company’s second-quarter 2012 financial results (the “August 2, 2012

Conference Call”), Defendant Surges commented on the “transparency [and] predictability” of

the Company’s new subscription-based business model. Defendant Surges explained that the

Company’s subscription revenue backlog figure would “predictably fall to the revenue ” during

future periods, meaning that growth in the subscription revenue backlog would lead to

“predictable growth in [future] revenue .”

36. Analysts believed Defendants’ representations regarding the “predictable”

correlation between subscription revenue backlog and future revenue. For example, on August

1, 2012, Imperial Capital wrote in pertinent part:

We expect unrecognized revenue backlog ($62mn as of 6/30/12; $34 mn of which is subscription) to grow at a faster pace than reported revenues over the next few quarters as more subscription-based contracts are signed and sequential growth as increased backlog flows through to the revenue line , improving EBITDA margins in the process.

37. Similarly, Craig-Hallum commented in pertinent part on August 2, 2012 that

“FY’13 should show strong growth in recurring/subscription revenue reflected by a growing

backlog over the next few quarters.”

C. The Company Reports Rapidly Increasing Subscription Revenue Backlog Figures During The Class Period Due To Purported Sales In Merge DNA’s eClinical Division

38. Over the six quarterly periods ended June 30, 2012 through September 30, 2013,

the subscription revenue backlog figures that Defendants reported to the market skyrocketed.

Indeed, Defendants reported the following subscription revenue backlog totals during this time

period:

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Operating As of June 30 As of As of As of March As of June As of Group 2012 September December 31, 2013 30, 2013 September

30, 2012 31, 2012 30, 2013

Merge DNA $22.2 M $29.5 M $34.9 M $40.9 M $50.4 M $56.4 M

Merge $11.9 M $10.9 M $10.7 M $11.8 M $11.5 M $13.2 M Healthcare

39. Recognizing the importance of Merge’s subscription revenue backlog to analysts

and investors, Defendants repeatedly highlighted the growth of this purportedly “predictable”

metric in their public statements to the market. Moreover, Defendants specifically attributed the

growth in Merge’s subscription revenue backlog to sales of eClinical’s recently launched

subscription-based clinical trials platform, eCOS.

40. For instance, discussing the Company’s second-quarter 2012 financial results on

the August 2, 2012 Conference Call, Defendant Oreskovich emphasized that: “ subscription

backlog has grown from $25 million at December 31, 2011 to $30 million at March 31 to $34

million at the end of Q2 due to the introduction of [subscription]-based pricing earlier in

2012 .” Similarly, Merge’s Form 10-Q for the second quarter of 2012 filed with the SEC on

August 6, 2012 (the “2Q 2012 Form 10-Q”) reported that “ subscription revenue backlog as of

June 30, 2012 was $34.1 million .”

41. On October 31, 2012, Merge boasted in the headline of its press release

announcing the Company’s third-quarter 2012 financial results (the “October 31, 2012 Press

Release”): “MERGE REPORTS 2012 SUBSCRIPTION BACKLOG UP 62% . . . .” In

particular, the October 31, 2012 Press Release highlighted that Merge’s “ eClinical segment

signed over 150 contracts in the quarter resulting in a greater than 100% growth in bookings .”

42. The following day, Defendant Oreskovich noted on Merge’s November 1, 2012

conference call with analysts and investors to discuss the Company’s third-quarter 2012 financial

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results (the “November 1, 2012 Conference Call”) that its “ subscription backlog has grown by

over $15 million, or 62% .” In addition, Defendant Oreskovich pointed out that “since the first

quarter, . . . our subscription backlog has increased in both healthcare and DNA, compared to

yearend . . . .”

43. Defendant Dearborn further stated during the November 1, 2012 Conference Call

that Merge DNA’s new eCOS platform “contributed to the great sales results for this group” as

“Q3 saw 25% growth in the number of sites using our solution, 40% growth in the number of

studies under contract, and well over 100% growth in bookings.” In response to an analyst’s

question as to whether Merge DNA’s strong performance during the quarter was attributable to

initial excitement following the launch of eCOS or something more sustainable, Defendant

Dearborn also stated:

A little of both . . .because . . . [t]here was some demand pent up there for that, but overall, I think, just, you see a maturing of the sales team as the new general manger is about 12 months old in the position . . . He brought in some new sales leadership down there quite quick. So, we do expect continued growth.

44. Moreover, when asked by an analyst how much of Merge DNA’s subscription

revenue backlog growth was attributed to eClinical’s performance, Defendant Dearborn

responded: “So, almost 100% of the increase in [Merge DNA’s] subscription backlog comes

from the eClinical group . As you know, we don’t segment out the revenue, but the strong

performance in the subscription backlog came out of the eClinical group .”

45. In their public statements to the market, Defendants specifically relied upon the

subscription revenue backlog figure as an indicator of the growth of Merge’s business. For

instance, during Merge’s August 9, 2013 conference call with analysts and investors to discuss

the Company’s second-quarter 2013 financial results (the “August 9, 2013 Conference Call”),

Defendant Dearborn stated that “ [o]ur Clinical Trials business is growing rapidly, as evidenced

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by the backlog growth of almost $30 million since our new platform launched one short year

ago.”

46. The market relied upon, and was impressed by, Merge’s representations regarding

its rising subscription revenue backlog figures. For example, on October 31, 2012, following the

Company’s announcement of its third-quarter 2012 financial results, an analyst at William Blair

noted that “[t]he Company reported solid subscription backlog of $40.4 million, with . . .a strong

$29.5 million in DNA.” Likewise, Dougherty & Company reported on November 1, 2012 that

“[t]otal subscription backlog ($71.4M, +42% Q/Q) grew with the growth in the eClinical product

backlog in the DNA business segment ($40.4M, + 18.5% Q/Q).” On November 2, 2012 Craig-

Hallum also emphasized that “[i]t is worth noting that the subscription backlog in the DNA

segment accounted for all of the backlog growth. . . .”

47. On February 19, 2013, Merge emphasized its subscription revenue backlog

growth in the headline of a press release announcing the Company’s fourth-quarter and year-end

2012 financial results (the “February 19, 2013 Press Release”): “ MERGE REPORTS

SUBSCRIPTION BACKLOG UP 82% -- Delivers fourth quarter sales of $65.1 million and

reiterates 2013 guidance of sales range of $265 -- $275 million.” The February 19, 2013 Press

Release further highlighted that “ eClinical signed over 190 contracts in the quarter driving year-

over-year bookings growth of 79%.”

48. That same day, on the Company’s conference call with analysts and investors to

discuss its fourth-quarter and year-end 2012 financial results (the “February 19, 2013 Conference

Call”), Defendant Surges stated: “ The second part of our strong quarter was fueled by growth

in our subscription backlog. It was up $20 million or 82% in 2012. ” Likewise, Defendant

Oreskovich noted during the February 19, 2013 Conference Call: “ We again experienced strong

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growth in subscription backlog of $5.2 million in Q4, to $45.6 million at year end. During

2012, subscription backlog grew by over $20 million, or 82% . . . .” In particular, Defendant

Surges reported on the February 19, 2012 Conference Call that “ eClinical bookings are up 79% ”

while Defendant Dearborn reiterated that bookings in Merge DNA “ increased 79% ” on a “full

year-over-year” basis. Also during the February 19, 2013 Conference Call, Defendant

Oreskovich explained that for “2012, obviously, a lot of the backlog growth came from the

DNA and specifically eClinical as we moved that entire business to subscription early in the

year as we saw we had an opportunity to do that.”

49. On February 19, 2013, after the Company announced its fourth-quarter and year-

end 2012 financial results, Dougherty & Company commented in pertinent part:

Total subscription backlog grew 82% y/y from a strong increase in the subscription backlog in the e-clinical business within the Merge DNA segment. While we would like to see growth in the healthcare subscription backlog, the overall subscription backlog growth despite the modest decline and a healthy pipeline are encouraging .

50. William Blair also highlighted on February 19, 2013 that “the subscription and

nonrecurring backlog was $76.9 million at the end of the quarter – with $10.7 million from

Merge Healthcare and $34.9 million coming from the Merge DNA segment (which reported

another very strong quarter, highlighted by a record 190 new contracts and 79% bookings

growth).” Similarly, on February 20, 2013, Craig-Hallum reported: “[T]otal subscription

backlog grew 13% since the prior quarter to $45.6M. The subscription backlog in the DNA

segment accounted for all of the backlog growth . . . .”

51. During the Company’s conference call with analysts and investors to discuss its

first-quarter 2013 financial results the following day (the “May 1, 2013 Conference Call”),

Defendant Surges reiterated that “ subscription backlog grew 16% in both of our operating

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groups .” Similarly, Defendant Oreskovich stated during the May 1, 2013 Conference Call that

Merge “again experienced strong growth in subscription backlog of $7.2 million in the quarter

to $52.8 million .” Defendant Oreskovich further commented that “ subscription backlog grew in

both segments with the clinical trials platform leading the growth .” In addition, Defendant

Dearborn stated on the May 1, 2013 Conference Call that Merge DNA “did sign 37 net new

clients in the quarter so a huge uptick there as well.”

52. Moreover, Merge’s Form 10-Q for the first quarter of 2013 filed with the SEC

that same day (the “1Q 2013 Form 10-Q”) reported as follows:

As of March 31, 2013 subscription revenue backlog was $52.8 million, compared to $30.4 million at March 31, 2012. This significant increase is the result of the continued success of our strategic plan to continue to move to the subscription model.

53. On April 30, 2013, following the announcement of Merge’s first-quarter 2013

financial results, William Blair reported on the growth in Merge’s backlog, noting that

“subscription backlog for Merge’s DNA segment grew $6 million from last quarter, to $40.9

million (up a strong 17% sequentially).” On May 1, 2013, Dougherty and Company additionally

commented that “[t]otal subscription backlog grew 75.5% y/y primarily from a strong increase in

the subscription backlog in the e-clinical business within the Merge DNA segment.” Similarly,

in a report issued on May 2, 2013, Craig-Hallum commented that “strong results out of the DNA

segment over the past few quarters in terms of backlog growth show that there is some real value

there.” Craig-Hallum further reported in pertinent part:

DNA Business a Hidden Asset. MRGE’s DNA business has been going strong for a few quarters now with revenues topping the $10M mark in Q1 and backlog (100% subscription) having grown from $22M in the Jun’12 quarter to $40M+ in the Mar’13 quarter. . . .Based on these multiples, at scale and assuming profitability, MRGE’s DNA business could be valued at $100M-$150M as a standalone. This would equate to ~$1.10-$1.60/share.

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D. Merge’s Reported Subscription Revenue Backlog Figures Were Recklessly Overstated

54. Defendants recklessly disregarded that their Class Period statements touting the

growth of the Company’s subscription revenue backlog were materially false and misleading

when made. Specifically, Defendants were alerted to, and/or should have been aware of,

material weaknesses in the Company’s internal control processes for recording customer

contracts and paying sales commissions, which left them without a reasonable factual basis for

making representations to investors regarding the Company’s subscription revenue backlog

during the Class Period. Indeed, as alleged herein, by exploiting these material weaknesses, a

former eClinical sales employee was able to falsify the amount and/or existence of over $15

million in customer contracts. As the Company has admitted, the amounts of these falsified

contracts “were included in the company’s previously-announced subscription backlog totals,”

thereby rendering its publicly reported subscription revenue backlog figures materially

overstated throughout the Class Period.

55. Contrary to Defendants’ Class Period statements touting the Company’s

subscription revenue backlog as a purportedly “predictable” indicator of future revenue,

Defendants and other senior management in Merge’s eClinical division knew and/or should have

known of material weaknesses in Merge’s internal controls, which severely undermined the

reliability and predictability of this metric. Indeed, these severe internal control deficiencies

caused at least $15 million in falsified contracts to be included in the subscription revenue

backlog figures that Merge reported to the market during the Class Period.

56. Throughout the Class Period, Defendants aggressively sought to increase

bookings for Merge’s subscription-based offerings at any cost, including the Company’s internal

control processes. Prior to the start of the Class Period, on June 25, 2012, the Company issued a

17


press release (the “June 25, 2012 Press Release”) announcing the launch of eCOS, a software-as-

a-service (“SaaS”) application offering an end-to-end solution for clients to design, deploy, and

manage clinical trials. Quoting Zaher El-Assi (“El-Assi”), the General Manager of eClinical, the

June 25, 2012 Press Release stated that “[w]ith Merge eClinical OS, clients can now utilize one

solution across all capabilities, which means one partner and one contract, and removes the

technical and administrative complexities typically associated with managing a trial.” The June

25, 2012 Press Release further emphasized that eCOS “provides cost transparency with step-by-

step, self-service quoting and decision support tools” as well as “pay-as-you-go pricing,” such

that “clients can minimize study costs by only paying for only the functionality they need, when

they need it.”

57. After the launch, eClinical’s senior management embarked on an aggressive

campaign to boost eCOS sales. For example, as described by Confidential Witness (“CW”) 1, a

Regional Manager in eClinical between July 2011 and June 2013, following the launch of eCOS,

eClinical’s senior management, including El-Assi, put significant pressure on eClinical sales

employees to book contracts for this new product, directing them to “just get them to sign” and

not to worry about the customer canceling the contract at a later date because they could “just

tear up the contract.”

58. Corroborating this testimony regarding senior management’s aggressive sales

approach, CW 2, who worked as a Senior Accountant in eClinical between October 2010 and

August 2012, noted that eClinical sales employees offered products to customers that were not

ready to be delivered, leading to contracts that could not be fulfilled.

59. Likewise, CW 3, who was employed as an Inside Sales Specialist in eClinical

between September 2012 and April 2014, noted that at the end of each quarter, El-Assi and the

18


Vice President of Sales, Ethan Rooney (“Rooney”) would continually praise the former sales

employee responsible for falsifying customer contracts. Moreover, at the end of Merge’s

quarters, El-Assi and Rooney would ask the former sales employee to reach out to customers to

“see if they could to do [the employee] any favors.”

60. Further, CW 3 noted critical flaws in eClinical’s internal control processes for

signing customer contracts and paying sales commissions. Specifically, CW 3 explained that

under eCOS’s “pay-as-you-go” pricing model, eClinical sales employees negotiated a Master

Service Agreement (“MSA”) with the customer, which was usually signed electronically by the

customer and then sent to Merge’s Contracts and Proposal Department and to El-Assi, for

counter-signing. However, the signing of the MSA had no financial implications for the

customer. Instead, when the customer wanted to use eCOS for a clinical study, the customer

completed and signed a “Configurator Quote,” which would determine the pricing for the

specific study. Unlike the MSA, the Configurator Quote was not sent to the Contracts and

Proposal Department, nor was it counter-signed by El-Assi. Rather, the sales employee was the

only individual at Merge who oversaw the completion and signing of the Configurator Quote.

61. The signing of the Configurator Quote would also allow the sales employee to

collect commissions on his or her “sale,” even though the customer had not yet been billed for

any services. Only when the customer “went live” with the study did billing begin. Other than

the Contract and Proposal Department’s review and El-Assi’s counter-signing of the MSA, there

was no other oversight over the contracting process.

62. According to CW 3, the gaps in Merge’s internal controls could be manipulated to

allow sales employees to collect unearned commissions in one of two possible ways. First, a

sales employee could collect commissions by asking a customer to submit a Configurator Quote

19


while assuring the customer that it would not be billed unless it “went live” with the study. CW

3 noticed this glaring flaw within a few months of working at Merge and specifically brought it

to El-Assi’s attention during the Class Period. However, El-Assi’s response was dismissive.

Second, a sales employee could falsify signed contracts by attaching the customer’s electronic

signature, which he or she would have access to by virtue of the signed MSA, to an illegitimate

Configurator Quote. Under this scenario, the customer would never become aware of the

falsified Configurator Quote because it would only be invoiced when the study “went live,”

which would never occur. Nevertheless, under either scenario, the sales employee would earn a

commission on the “sale,” and the “sale” would be incorporated into Merge’s subscription

revenue backlog.

63. CW 1 also confirmed that customers were not billed for eCOS until the clinical

study was launched, which the customer did directly through the software by clicking the “go

live” button. However, even after launching the study, eCOS customers could terminate their

use at any time without any financial repercussions.

64. CW 2 confirmed these deficiencies in eClinical’s processes for signing customer

contracts and paying sales commissions, commenting that the former sales employee’s

falsification of contracts in eClinical was not surprising because “shady stuff” happened with

regard to how revenue was recognized and customers were induced into entering contracts in

eClinical. In particular, CW 2 stated that according to eClinical’s internal guidelines, sales

employees negotiated the contract terms with the customer. After the terms of the contract were

agreed upon, the customer signed the contract, which was then sent to upper management for

review. The accounting department was not supposed to recognize revenue or pay sales

commissions until it received a signed contract. However, CW 2 would often receive

20


instructions either verbally or via e-mail directly from Defendant Dearborn or El-Assi to

recognize revenue and pay sales commission before receiving a signed contract. Usually, neither

Dearborn nor El-Assi provided any reasons for the break in Merge’s internal control procedures,

simply telling CW 2 “don’t worry about it” and that the contract would be signed. At other

times, they explained to CW 2 that they needed to record the contract so they could pay a

commission to the sales employee, even though a contract had not yet been signed by the

customer. CW 2 also stated that sometimes, the Company would recognize revenue and pay

commissions – which it never rescinded – based upon unfulfilled contracts. CW 4, a director of

sales in eClinical between September 2012 and October 2013, echoed these sentiments,

describing Merge as a “mess of an organization,” and noting that El-Assi and Rooney believed in

closing a sale at all costs, often encouraging salespersons to “just get [customers] to sign” a

contract.

65. By no later than June 2013, eClinical’s senior management became suspicious

that customer contracts for eCOS were potentially being falsified. According to CW 3, El-Assi

sent an email around that time to the former eClinical sales employee responsible for falsifying

contracts to inquire about a sale that had not closed. El-Assi also became suspicious of glaring

discrepancies between eClinical’s reported subscription revenue backlog figures and its

recognized revenue. However, as set forth above, it was not until over six months later in

January 2014 that the Company publicly revealed its discovery of these inflated subscription

revenue backlog numbers.

E. The Truth Begins To Emerge

66. On August 9, 2013, Merge stunned investors when it issued a press release

announcing the Company’s second-quarter 2013 financial results (the “August 9, 2013 Press

Release”), which reported that the Company’s sales had decreased from the prior year period by

21


nearly 10% - from $62.9 million to $57.2 million - and that Defendant Surges had resigned as

CEO and would be replaced by Defendant Dearborn. Less than three weeks later, Defendant

Ferro, Merge’s Chairman, also resigned. Defendants blamed Merge Healthcare for the

Company’s weak performance during the second quarter of 2013, stating that the Company “saw

a continued reluctance among large health systems to move forward with enterprise purchases.”

67. However, the August 9, 2013 Press Release also revealed that despite a 180%

increase in the reported subscription revenue backlog for eCOS since the launch of this new

platform, from $16 million to $45 million, Merge DNA’s purportedly “predictable” subscription-

based revenue stream remained relatively flat during the quarter, increasing by just 5.2% from

$7.7 million to $8.1 million. This marked discrepancy between Merge DNA’s subscription

revenue backlog growth and the growth in its reported subscription-based revenue called into

question the veracity of the Company’s reported subscription revenue backlog and Defendants’

prior representations that Merge’s subscription revenue backlog would predictably translate into

recognized revenues.

68. Nevertheless, Defendants continued to highlight the growth of Merge’s

subscription revenue backlog as a signal that the Company’s future was bright. For instance,

during Merge’s August 9, 2013 conference call with analysts and investors to discuss the

Company’s second-quarter 2013 financial results (the “August 9, 2013 Conference Call”),

Defendant Dearborn reiterated that “ [o]ur Clinical Trials business is growing rapidly, as

evidenced by the backlog growth of almost $30 million since our new platform launched one

short year ago.” Specifically, Defendant Dearborn highlighted that “[i]n the past year, since the

launch of our new platform, eClinical OS or eCOS, backlog has grown from $16 million to $45

million, and our revenues and margins have expanded, as well.” Defendant Oreskovich also

22


emphasized that “[w]e again experienced strong growth in subscription backlog of $9.1 million

in the quarter, to $61.9 million overall, which balance has grown by 82% in the last 12

months.”

69. On August 9, 2013, after Merge released its second-quarter 2013 financial results,

William Blair noted that, despite the Company’s weak performance overall, “there is a lingering

demand in the marketplace for Merge’s innovative imaging and clinical trials solutions, as

evidenced by total backlog growing to $86.8 million in the quarter, up 13.5% from last quarter.”

William Blair further acknowledged that “the majority of the growth came from the DNA

segment, and, even more specifically, the clinical trials business within the DNA segment (again

recently run by the newly appointed CEO), which saw backlog increase 29% sequentially to

$45.7 million at the end of the quarter.”

70. Craig-Hallum similarly noted in a report issued on August 12, 2013 that “[t]he

DNA business continues to track well with a growing backlog.” In addition, Craig-Hallum

reported that “subscription backlog grew from $52.7M to $61.9M sequentially, with all growth

coming from the DNA segment.”

71. After replacing Defendant Surges as CEO of the Company, Defendant Dearborn

continued to characterize subscription revenue backlog as a predictable measure of Merge’s

future revenues. For example, when asked in an October 28, 2013 interview with the Wall Street

Transcript what milestones or indicators investors should consider with regard to Merge’s future

prospects, Defendant Dearborn responded: “ The backlog is a good indicator. You’re building a

nice recurring base for the future and again, we try to really hammer that home on earnings

calls.”

23


72. Continuing to emphasize the growth in Merge’s subscription revenue backlog

figures, Merge highlighted in its October 30, 2013 press release announcing the Company’s

third-quarter 2013 financial results (the “October 30, 2013 Press Release”) that it “[s]aw

eClinical backlog increase $29.5 million (127%) to $52.8 million in the third quarter of 2013,

from $23.3 million in the third quarter of 2012.” Likewise, Defendant Dearborn noted during

Merge’s October 30, 2013 conference call with analysts and investors to discuss the Company’s

third-quarter 2013 financial results (the “October 30 Conference Call”) that Merge DNA’s

subscription revenue “backlog increased by 127% in the past year ” Analysts again seized on

these subscription revenue backlog figures, with William Blair highlighting on October 30, 2013

that “subscription backlog for Merge’s DNA segment grew $6 million from last quarter, to $56.4

million (up a solid 12% sequentially).”

F. Defendants Finally Confirm The Falsity Of Merge’s Subscription Revenue Backlog

73. On January 8, 2014, Merge shocked investors when it identified, for the first time,

in a press release titled “Merge Revises Previously-Announced Subscription Backlog Totals”

(the “January 8, 2014 Press Release”), severe deficiencies in the Company’s internal controls

over its processes for logging customer contracts and calculating commissions for its sales

personnel.

74. Specifically, the Company confirmed in the January 8, 2014 Press Release that by

exploiting these deficiencies, “a former sales employee in its eClinical business had falsified the

existence or amount of certain customer contracts,” which had caused eClinical’s reported sales

to be materially overstated by millions of dollars for six quarterly periods.

75. The Company further revealed in the January 8, 2014 Press Release that “the

former employee had falsified contracts with an apparent value of approximately $5.8 million

24


and $9.4 million in 2012 and 2013, respectively,” and that “[t]hese amounts were included in the

company’s previously-announced subscription backlog totals during those years.” As a result,

Defendants revealed that Merge DNA’s previously-disclosed subscription revenue backlog

figures were overstated by the following amounts:

fwu s vi 11io .aiidsi September December September

June 30, 30, 31, March 31, June 30. 30, 2012 2012 2012 2013 2013 2013

Pr6ou51y AIIIIOUHed DNA

Subscription Backlog S 2.213 $ 29.453 S 34.917 S 40.943 S 50.409 S 56.370

Fasified Bookings illQuarter S 277 S 172 $ 5.360 $ 2364 S 4.304 S 2.114 Cumulative Falsified Bookings 277 S 449 5.809 S 9.673 S 12.977 S 15.151

Revised DNA Subscription BackloatQuanerEud S 21.936 S 29.004 3 29,108 S 32.270 S 37.432 S 41.219

76. The January 8, 2014 Press Release stated that these overstated subscription

revenue backlog figures did not reach the Company’s revenue line because “the company did

not, and will not, invoice the customers with respect to the falsified contracts.”

77. In the January 8, 2014 Press Release, Defendants stated that after becoming

alerted to the falsified contracts, the Company engaged independent consultants, including

Jenner & Block LLP and Alvarez & Marsal Global Forensic and Dispute Services, LLC to

investigate the matter. Defendants also noted that the sales employee who falsified the contracts

“resigned in September 2013” and “falsified these contracts in order to achieve sales quotas and

receive additional commissions totaling approximately $250,000.”

78. In addition, effectively conceding that Defendants were reckless in failing to

discover the sales employee’s fraud due to a lack of internal Company controls, Merge further

disclosed in the January 8, 2014 Press Release, in pertinent part, as follows:

The [C]ompany’s senior management has identified, and its Board of Directors has adopted, other modifications to the [C]ompany’s internal controls to

25


strengthen its processes for logging customer contracts and calculating commissions for its sales personnel. While the [C]ompany believes its corrective measures will significantly reduce the likelihood of similar occurrences, there can be no assurances in this regard.

VI. DEFENDANTS’ FALSE AND MISLEADING STATEMENTS

A. August 1, 2012 Form 8-K

79. On July 31, 2012, Merge issued a press release announcing the Company’s

second-quarter 2012 financial results for the period ended June 30, 2012 (the “July 31, 2012

Press Release”). The July 31, 2012 Press Release was attached to a Form 8-K that Merge

publicly filed with the SEC on August 1, 2012 (the “August 1, 2012 Form 8-K”).

80. The July 31, 2012 Press Release reported that total subscription revenue backlog

for the Merge DNA operating group was $22.2 million as of June 30, 2012. This figure was

repeated in the Form 10-Q for the second quarter of 2012 that Merge filed with the SEC on

August 6, 2012 (the “August 6, 2012 Form 10-Q”).

81. The foregoing statements were materially false and misleading when made

because Merge DNA’s publicly reported subscription revenue backlog figures were materially

overstated throughout the Class Period. Specifically, because of the reckless lack of proper

internal controls to monitor and oversee the input of new contracts and backlog figures into the

Merge computer system, a former sales employee in its eClinical business was able to easily

falsify “the existence or amount of certain customer contracts.” As a result, the subscription

revenue backlog figure that Merge reported for the second quarter of 2012 was overstated by

$277,000.

26


B. August 2, 2012 Conference Call

82. On August 2, 2012, Merge held a conference call with analysts and investors to

discuss the Company’s second-quarter 2012 financial results. In his opening remarks on the

August 2, 2012 Conference Call, Defendant Surges stated:

Last quarter we made a bold move by announcing our transition to a subscription-based pricing model to align more closely with our clients’ long-term operating plans. I am happy to report that we continue to see the client willingness to adopt this type of purchasing model, which included subscription-based contracts totaling approximately $2 million.

83. Defendant Surges’ statement that Merge signed subscription-based contracts

totaling approximately $2 million during the second quarter of 2012 was materially false and

misleading when made. Specifically, because of the reckless lack of proper internal controls to

monitor and oversee the input of new contracts and backlog figures into the Merge computer

system, a former sales employee in its eClinical business was able to easily falsify “the existence

or amount of certain customer contracts.” As a result, the subscription revenue backlog figure

that Merge reported for the second quarter of 2012 was overstated by $277,000.

84. Defendant Oreskovich also commented on the Company’s second-quarter 2012

financial results during the August 2, 2012 Conference Call, noting with regard to the

Company’s subscription revenue backlog for the quarter:

For those of you who like to model the business, subscription backlog has grown from $25 million at December 31, 2011 to $30 million at March 31 to $34 million at the end of Q2 due to the introduction of [subscription]-based pricing earlier in 2012 and the length of our customer sales cycles. We would expect these types of arrangements to become more prevalent in the second half of 2012 and beyond.

Likewise, in its August 6, 2012 Form 10-Q, the Company reiterated the fact that its overall

subscription revenue backlog was $34.1 million as of June 30, 2012.

27



because Merge DNA’s publicly reported subscription revenue backlog figures were fraudulently

and materially overstated throughout the Class Period. Specifically, because of the reckless lack

of proper internal controls to monitor and oversee the input of new contracts and backlog figures

into the Merge computer system, a former sales employee in its eClinical business was able to

easily falsify “the existence or amount of certain customer contracts.” As a result, the

subscription revenue backlog figure that Merge reported for the second quarter of 2012 was

overstated by $277,000.

C. August 6, 2012 Form 10-Q

86. On August 6, 2012, Merge filed with the SEC a Form 10-Q for the second quarter

of 2012, which was signed and certified pursuant to Sections 302 and 906 of the Sarbanes-Oxley

Act of 2002 (“SOX”) by Defendants Surges and Oreskovich. In addition to the foregoing

statements regarding Merge’s subscription revenue backlog, the August 6, 2012 Form 10-Q

stated the following with respect to the adequacy of the Company’s internal controls:

We evaluated the effectiveness of the design and operation of our disclosure controls and procedures, which were designed to provide reasonable assurance of achieving their objectives, as of June 30, 2012, as required by Rule 13a-15 of the Exchange Act. This evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, as of June 30, 2012, our disclosure controls and procedures were effective at the reasonable assurance level to ensure (1) that information required to be disclosed to us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and (2) information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.


because Merge’s internal controls were grossly ineffective and routinely overridden by

28


Defendants during the Class Period. Specifically, CW 1 stated that eClinical’s senior

management pressured sales employees to engage in aggressive sales tactics, which led to

commissions being paid on contracts that were ultimately cancelled. Similarly, CW 2 stated that

Defendant Dearborn, as well as other senior management, instructed eClinical’s accounting

personnel to disregard the Company’s internal guidelines regarding the recording of revenues

and the payment of sales commissions. Finally, CW 3 stated that eClinical’s senior management

failed to address known material weaknesses in eClinical’s processes for recording customer

contracts and paying commissions, such that eClinical sales employees could collect

commissions on unfulfilled and/or falsified contracts.

D. October 31, 2012 Press Release

88. On October 31, 2012, Merge issued a press release announcing the Company’s

third-quarter 2012 financial results for the period ended September 30, 2012. The October 31,

2012 Press Release was attached to a Form 8-K that Merge publicly filed with the SEC on

November 6, 2012 (the “November 6, 2012 Form 8-K”)

89. The October 31, 2012 Press Release, captioned “MERGE REPORTS 2012

SUBSCRIPTION BACKLOG UP 62% - Delivers third quarter revenue of $61 million and

announces 2013 guidance of pro forma revenue range of $265 - $275 million,” highlighted the

growth of the Company’s subscription revenue backlog, stating that “ subscription backlog grew

62% since the prior year end [.]” The October 31, 2012 Press Release also reported that total

subscription revenue backlog for the Merge DNA operating group was $29.5 million as of

September 30, 2012.

90. The foregoing statements regarding Merge’s subscription revenue backlog were

materially false and misleading when made because Merge DNA’s publicly reported

subscription revenue backlog figures were fraudulently and materially overstated throughout the

29


Class Period. Specifically, because of the reckless lack of proper internal controls to monitor

and oversee the input of new contracts and backlog figures into the Merge computer system, a

former sales employee in its eClinical business was able to easily falsify “the existence or

amount of certain customer contracts.” As a result, the subscription revenue backlog figure that

Merge reported for the third quarter of 2012 was overstated by $449,000.

E. November 1, 2012 Conference Call

91. On November 1, 2012, Merge held a conference call with analysts and investors

to discuss the Company’s third-quarter 2012 financial results. A transcript of the November 1,

2012 Conference Call was publicly filed with the SEC as an attachment to the November 6, 2012

Form 8-K.

92. Reporting on the Merge DNA operating group during the November 1, 2012

Conference Call, Defendant Dearborn emphasized client adoption of Merge DNA’s subscription-

based offerings and the Company’s subscription-based revenue, including the growth of Merge

DNA’s subscription revenue backlog, stating in pertinent part:

. . . As I mentioned on our last call, our eClinical group released a new platform during the last week of Q2. Our new platform, called Merge eClinical OS, is a software to service application, offering an end to end solution for clients to design, deploy, and manage clinical trials. During Q3, this new platform contributed to the great sales results for this group. Q3 saw 25% growth in the number of sites using our solution, 40% growth in the number of studies under contract, and well over 100% growth in bookings.

We saw strong demand across all customer segments, with especially strong demand from our CRO channel. We signed over 150 contracts in Q3, far exceeding our best quarter . . . . * * *

From a financial perspective this quarter, Merge DNA generated $7.6 million pro forma revenue, with a 7% adjusted EBITDA margin. Further, subscription revenue comprised over 90% of total revenue for this operating group, while backlog at September 30 grew $7 million to $29 million and is 100% subscription revenue based.

30


93. With regard to the Company’s financial results for the third quarter, Defendant

Oreskovich discussed the growth of the Company’s subscription revenue backlog, stating that

the “subscription backlog has grown by over $15 million, or 62% .”

94. The foregoing statements by Defendants Dearborn and Oreskovich were







Merge reported for the third quarter of 2012 was overstated by $449,000.

F. November 2, 2012 Form 10-Q

95. On November 2, 2012, Merge filed with the SEC a Form 10-Q for the third

quarter of 2012 (the “3Q 2012 Form 10-Q”), which was signed and certified pursuant to SOX

Sections 302 and 906 by Defendants Surges and Oreskovich. The 3Q 2012 Form 10-Q

contained similar representations concerning the Company’s total subscription revenue backlog,

stating in pertinent part that “ subscription revenue backlog as of September 30, 2012 was $40.3

million. ” The 3Q 2012 Form 10-Q also reported that total subscription revenue backlog for the

Merge DNA operating group was $29.5 million as of September 30, 2012.


because Merge DNA’s publicly reported subscription revenue backlog figures were fraudulently

and materially overstated throughout the Class Period. Specifically, because of the reckless lack

of proper internal controls to monitor and oversee the input of new contracts and backlog figures

into the Merge computer system, a former sales employee in its eClinical business was able to

31


easily falsify “the existence or amount of certain customer contracts.” As a result, the

subscription revenue backlog figure that Merge reported for the third quarter of 2012 was

overstated by $449,000.

97. Regarding the adequacy of the Company’s internal controls, the 3Q 2012 Form

10-Q also stated in pertinent part:

We evaluated the effectiveness of the design and operation of our disclosure controls and procedures, which were designed to provide reasonable assurance of achieving their objectives, as of September 30, 2012, as required by Rule 13a-15 of the Exchange Act. This evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, as of September 30, 2012, our disclosure controls and procedures were effective at the reasonable assurance level to ensure (1) that information required to be disclosed to us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and (2) information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.










32




G. February 19, 2013 Press Release And Conference Call

99. On February 19, 2013, Merge issued a press release announcing the Company’s

fourth-quarter and year-end 2012 financial results for the period ended December 31, 2012. The

February 19, 2013 Press Release was attached to a Form 8-K that Merge publicly filed with the

SEC on February 21, 2013 (the “February 21, 2013 Form 8-K”)

100. The February 19, 2013 Press Release, captioned “ MERGE REPORTS

SUBSCRIPTION BACKLOG UP 82% - Delivers fourth quarter sales of $65.1 million and

reiterates 2013 guidance of sales range of $265 - $275 million,” emphasized the Company’s total

subscription revenue backlog, stating in pertinent part that “ subscription backlog grew 13% in

the quarter and 82% for the year [.]”

101. The foregoing statements regarding the growth in Merge’s subscription revenue

backlog were materially false and misleading when made because Merge DNA’s publicly

reported subscription revenue backlog figures were fraudulently and materially overstated

throughout the Class Period. Specifically, because of the reckless lack of proper internal controls

to monitor and oversee the input of new contracts and backlog figures into the Merge computer



that Merge reported as of December 31, 2012 was overstated by $5,809,000.

102. Also on February 19, 2013, Merge held a conference call with analysts and

investors to discuss the Company’s fourth-quarter and year-end 2012 financial results. A

transcript of the February 19, 2013 Conference Call was publicly filed as an attachment to the

February 21, 2013 Form 8-K.

33


103. In his opening remarks on the February 19, 2013 Conference Call, Defendant

Surges made representations regarding total subscription revenue backlog, stating in pertinent

part:

Our Healthcare bookings are up 40% year over year, while eClinical bookings are up 79%. Additionally, we grew our subscription backlog by 82% , while still maintaining our non-recurring backlog. To me, it’s very clear that we’ve made substantial progress.

* * *

The second part of our strong quarter was fueled by growth in our subscription backlog. It was up $20 million or 82% in 2012 . . . .

* * *

We expect to see continued traction from our subscription-based offerings resulting in an increase in backlog of at least $25 million or 50-plus percentage growth by the end of 2013 , with pro forma revenue between $265 million and $275 million, and adjusted EBITDA growing to 22% to 24%. . . .

104. Defendant Oreskovich reiterated these statements, noting that

We again experienced strong growth in subscription backlog of $5.2 million in Q4, to $45.6 million at year end . During 2012, subscription backlog grew by over $20 million, or 82% . . . .

105. Providing an update on the Merge DNA operating group during the February 19,

2013 Conference Call, Defendant Dearborn similarly noted that “backlog at December 30 grew

$5.5 million to $34.9 million,” and that bookings “increased 79%” on a “full year-over-year”

basis.

106. The foregoing statements regarding the growth in Merge’s bookings and

subscription revenue backlog were materially false and misleading when made because Merge

DNA’s publicly reported subscription revenue backlog figures were fraudulently and materially

overstated throughout the Class Period. Specifically, because of the reckless lack of proper

internal controls to monitor and oversee the input of new contracts and backlog figures into the

34


Merge computer system, a former sales employee in its eClinical business was able to easily

falsify “the existence or amount of certain customer contracts.” As a result, the subscription

revenue backlog figure that Merge reported as of December 31, 2012 was overstated by

$5,809,000.

H. March 11, 2013 Form 10-K

107. On March 11, 2013, Merge filed its annual report with the SEC on Form 10-K for

the year ended December 31, 2012, which was signed by each of the Individual Defendants and

certified pursuant to SOX Sections 302 and 906 by Defendants Surges and Oreskovich. The

2012 Form 10-K contained similar representations concerning Merge’s subscription revenue

backlog, stating in pertinent part that “subscription revenue backlog as of December 31, 2012

was $45.6 million.” The 2012 Form 10-K also reported that total subscription revenue backlog

for the Merge DNA operating group was $34.9 million as of December 31, 2012.








Merge reported as of December 31, 2012 was overstated by $5,809,000.

109. Regarding the adequacy of the Company’s internal controls, the 2012 Form 10-K

also stated in pertinent part:

(a) Disclosure Controls and Procedures * * *

Our management has evaluated, under the supervision and with the participation

35


of our Chief Executive Officer, the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2012. Based on their evaluation as of December 31, 2012, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rule 13a-5(e) and 15d-5(e) under the Securities Exchange Act of 1934, as amended) were effective at the reasonable assurance level to ensure that the information required to be disclosed by us in this Annual Report on Form 10 K was (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations and (ii) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

(b) Management’s Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external reporting purposes in accordance with GAAP.

Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2012, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated Framework. Based on its assessment, management concluded that our internal control over financial reporting was effective as of December 31, 2012. The effectiveness of our internal control over financial reporting as of December 31, 2012 has been audited by BDO USA, LLP, an independent registered public accounting firm, as stated in the its report which is included below.










36




I. April 30, 2013 Press Release

111. On or about April 30, 2013, Merge issued a press release announcing the

Company’s first-quarter 2013 financial results for the period ended March 31, 2013. The April

30, 2013 Press Release was attached to a Form 8-K that Merge publicly filed with the SEC on

May 6, 2013 (the “May 6, 2013 Form 8-K). 2

112. The April 30, 2013 Press Release highlighted the Company’s total subscription

revenue backlog, stating in pertinent part that “ subscription backlog grew 16% in the quarter

and 74% in the last year ” and “[b]acklog in the DNA segment grew from $34.9M to $40.9M

and is 100% subscription revenue based .”

113. The foregoing statements regarding the growth in Merge’s subscription revenue

backlog were materially false and misleading when made because Merge DNA’s publicly

reported subscription revenue backlog figures were fraudulently and materially overstated

throughout the Class Period. Specifically, because of the reckless lack of proper internal controls

to monitor and oversee the input of new contracts and backlog figures into the Merge computer



that Merge reported for the first quarter of 2013 was overstated by $8,673,000.

J. May 1, 2013 Form 10-Q

114. On May 1, 2013, Merge filed with the SEC a Form 10-Q for the first quarter of

2013, which was signed and certified by Defendants Surges and Oreskovich pursuant to SOX

2 While the press release itself is dated May 1, 2013, the May 6, 2013 Form 8-K states that it was issued on April 30, 2013.

37


Sections 302 and 906. The 1Q 2013 Form 10-Q stated in pertinent part with regard to the

Company’s subscription revenue backlog:

As of March 31, 2013 subscription revenue backlog was $52.8 million, compared to $30.4 million at March 31, 2012. This significant increase is the result of the continued success of our strategic plan to continue to move to the subscription model.

115. In addition, the 1Q 2013 Form 10-Q reported that total subscription revenue

backlog for the Merge DNA operating group was $40.9 million as of March 31, 2013.








Merge reported for the first quarter of 2013 was overstated by $8,673,000.



We evaluated the effectiveness of the design and operation of our disclosure controls and procedures, which were designed to provide reasonable assurance of achieving their objectives, as of March 31, 2013, as required by Rule 13a-15 of the Exchange Act. This evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, as of March 31, 2013, our disclosure controls and procedures were effective at the reasonable assurance level to ensure (1) that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and (2) information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to our management,

38


including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.












K. May 1, 2013 Conference Call

119. On May 1, 2013, Merge held a conference call with analysts and investors to

discuss the Company’s first-quarter 2013 financial results. A transcript of the May 1, 2013

Conference Call was publicly filed as an attachment to the May 6, 2013 Form 8-K.

120. Reporting on the Company’s first-quarter 2013 operating results during the May

1, 2013 Conference Call, Defendant Oreskovich touted the Company’s total backlog, stating that

Merge “again experienced strong growth in subscription backlog of $7.2 million in the quarter

to $52.8 million , which is easily on pace to achieve the guidance of an increase of $25 million

for 2013.” He went on to state that “ subscription backlog grew in both segments with the

clinical trials platform leading the growth .”

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121. Further, with respect to Merge DNA, Defendant Dearborn stated that “[b]acklog

at March 31 grew from $34.9 million to $40.9 million and is 100% subscription revenue based.

In the past year, subscription backlog has grown by more than 100%.”








Merge reported for the first quarter of 2013 was overstated by $8,673,000

L. August 9, 2013 Press Release And Conference Call

123. On August 9, 2013, Merge issued a press release announcing the Company’s

second-quarter 2013 financial results for the period ended June 30, 2013. The August 9, 2013

Press Release was attached to a Form 8-K that Merge publicly filed with the SEC on the same

day.

124. The August 9, 2013 Press Release highlighted the Company’s subscription

revenue backlog, reporting that: (i) “subscription backlog grew 82% since the second quarter of

2012;” and (ii) “[b]acklog for the quarter in the clinical trials segment, which is 100%

subscription revenue based, grew from $35.5M at the end of the first quarter of 2013 to $45.7M

at the end of the second quarter of 2013.” The August 9, 2013 Press Release additionally

reported that total subscription revenue backlog for the Merge DNA operating group was $50.4

million as of June 30, 2013.

40









Merge reported for the second quarter of 2013 was overstated by $12,977,000.

126. Also on August 9, 2013, Merge held a conference call with analysts and investors

to discuss the Company’s second-quarter 2013 financial results. During the August 9, 2013

Conference Call, Defendant Dearborn continued to tout the growth of Merge DNA’s

subscription revenue backlog, stating in pertinent part:

Our Clinical Trials business is growing rapidly, as evidenced by the backlog growth of almost $30 million since our new platform launched one short year ago.

* * *

In the past year, since the launch of our new platform, eClinical OS or eCOS, backlog has grown from $16 million to $45 million, and our revenues and margins have expanded , as well.

127. In addition, Defendant Oreskovich highlighted the growth of the Company’s

subscription revenue backlog, stating in pertinent part:

We again experienced strong growth in subscription backlog of $9.1 million in the quarter, to $61.9 million overall, which balance has grown by 82% in the last 12 months. Backlog growth was driven by the clinical trials platform, which comprises 75% of the total at June 30.




41







M. August 9, 2013 Form 10-Q

129. Also on August 9, 2013, Merge filed with the SEC a Form 10-Q for the second


Sections 302 and 906 by Defendants Dearborn and Oreskovich. The 2Q 2013 Form 10-Q stated

in pertinent part with regard to the Company’s subscription revenue backlog:

As of June 30, 2013 subscription revenue backlog was $61.9 million, compared to $34.1 million at June 30, 2012. This significant increase is the result of the continued success of our strategic plan to continue to move to a subscription model.


backlog for the Merge DNA operating group was $50.4 million as of June 30, 2013.









42




We evaluated the effectiveness of the design and operation of our disclosure controls and procedures, which were designed to provide reasonable assurance of achieving their objectives, as of June 30, 2013, as required by Rule 13a-15 of the Exchange Act. This evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, as of June 30, 2013, our disclosure controls and procedures were effective at the reasonable assurance level to ensure (1) that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and (2) information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.












43


N. October 30, 2013 Press Release And Conference Call

134. On October 30, 2013, Merge issued a press release announcing the Company’s

third-quarter 2013 financial results for the period ended June 30, 2013. The October 30, 2013

Press Release was attached to a Form 8-K that Merge publicly filed with the SEC on the same

day.

135. The October 30, 2013 Press Release touted the growth of the Company’s

subscription revenue backlog, quoting Defendant Dearborn as stating in pertinent part that “[w]e

. . . grew our subscription-based backlog.” Specifically, the October 30, 2013 Press Release

stated that: (i) “[s]ubscription backlog grew 73% since the third quarter of 2012, with growth in

both Merge Healthcare and DNA segments;” and (ii) the Company “[s]aw eClinical backlog

increase $29.5 million (127%) to $52.8 million in the third quarter of 2013, from $23.3 million in

the third quarter of 2012.” The October 30, 2013 Press Release further reported that total

subscription revenue backlog in the Merge DNA operating group was $56.4 million as of

September 30, 2013.








Merge reported for the third quarter of 2013 was overstated by $15,151,000.

137. On the same day, Merge also held a conference call with analysts and investors to

discuss the Company’s third-quarter 2013 financial results. During the October 30, 2013

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Conference Call, Defendant Dearborn reiterated the fact that Merge DNA’s “backlog increased

by 127% in the past year.”

138. Also during the October 30, 2013 Conference Call, Defendant Oreskovich

highlighted growth of the Company’s subscription revenue backlog, stating that Merge’s

“subscription backlog had sequential quarter growth of $7.6 million to $69.5 million in Q3 and

73% of growth in the last 12 months.”









O. November 4, 2013 Form 10-Q

140. On November 4, 2013, Merge filed with the SEC a Form 10-Q for the third


Sections 302 and 906 by Defendants Dearborn and Oreskovich.

141. With regard to the Company’s subscription revenue backlog, the 3Q 2013 Form

10-Q stated in pertinent part:

As of September 30, 2013 subscription revenue backlog was $69.5 million, compared to $40.3 million at September 30, 2012. This significant increase is the result of our strategic plan to continue to move to a subscription model.


backlog for the Merge DNA operating group was $56.4 million as of September 30, 2013.

45












We evaluated the effectiveness of the design and operation of our disclosure controls and procedures, which were designed to provide reasonable assurance of achieving their objectives, as of September 30, 2013, as required by Rule 13a-15 of the Exchange Act. This evaluation was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer. Based on this evaluation, our principal executive officer and principal financial officer have concluded that, as of September 30, 2013, our disclosure controls and procedures were effective at the reasonable assurance level to ensure (1) that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and (2) information required to be disclosed by us in our reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.






46








VII. LOSS CAUSATION

146. Defendants’ unlawful conduct alleged herein directly and proximately caused the

foreseeable losses suffered by Lead Plaintiff and the Class. The material false and misleading

statements and omissions set forth above were widely disseminated to the securities markets,

investment analysts, and the investing public. These material false and misleading statements

and omissions regarding, inter alia, the magnitude of Merge’s subscription revenue backlog and

the glaring deficiencies in its internal controls caused Merge’s common stock to trade at

artificially-inflated prices throughout the Class Period.

147. As the true facts became known, the price of Merge common stock declined,

causing damage to Lead Plaintiff and the Class. Specifically, through a series of partial

disclosures in August 2013 and January 2014, Defendants revealed the falsity of their prior

representations regarding Merge’s subscription revenue backlog and internal controls, and/or

disclosed to the market that risks previously concealed by Defendants’ materially false and

misleading statements and omissions had materialized.

148. On August 9, 2013, Merge shocked investors when it reported its financial results

for the second quarter of 2013. Specifically, the Company reported that its net sales decreased

by nearly 10% year-over-year, and that its quarterly net loss ballooned to $28.1 million, as

compared to $5.9 million during the second quarter of 2012. Moreover, despite having

47


previously reported explosive growth in its subscription revenue backlog (including an 82%

increase in backlog between the second quarter of 2012 and the second quarter of 2013), and

representing that Merge’s reported subscription revenue backlog would predictably translate into

future revenues, the Company disclosed that Merge DNA’s subscription-based revenues

increased by just 5.2% during the second quarter of 2013. That same day, the Company also

announced the abrupt resignation of Defendant Surges.

149. Defendants’ false and misleading statements and omissions concerning Merge

DNA’s subscription revenue backlog concealed the risk that the Company’s reported

subscription revenue backlog was not a reliable indicator of future revenues and would not

“predictably” translate into increased revenues for Merge DNA, as Defendants represented to

investors. These concealed risks began to materialize with Merge’s August 9, 2013 disclosures.

Specifically, the Company’s disclosure of lackluster revenue growth in the Merge DNA segment,

despite record growth in Merge DNA’s subscription revenue backlog throughout the Class

Period, revealed for the first time the unpredictability of Merge DNA’s subscription-based

revenue model and alerted investors to the fact that Merge’s previously-reported subscription

revenue backlog figures would not reliably translate into revenues for Merge DNA, as

Defendants had formerly represented.

150. It was foreseeable to Defendants that the numerous internal control deficiencies

alleged herein would cause Merge’s subscription revenue backlog figures to be materially

inflated during the Class Period. It was likewise foreseeable to Defendants that the

overstatement of Merge’s subscription revenue backlog figures during the Class Period would

conceal the risk that, inter alia, Merge’s reported subscription revenue backlog figures would not

48


be predictive of future revenues, and that the materialization of this concealed risk would cause

the price of Merge’s common stock to decline.

151. Defendants’ August 9, 2013 disclosures therefore partially revealed the truth

regarding the fraudulent conduct alleged herein. In response to Defendants’ August 9, 2013

disclosures, Merge’s common share price fell by $2.07 per share, or 46%, from a close of $4.50

per share on August 8, 2013 to $2.43 on August 9, 2013. This single-day decline in Merge’s

share price destroyed more than $193 million in market capitalization for the Company.

152. However, Defendants’ August 9, 2013 statements did not reveal the full truth

regarding Defendants’ fraud, as investors remained unaware that Merge DNA’s subscription

revenue backlog figures had been recklessly overstated throughout the Class Period. Instead,

throughout the remainder of the year, Defendants continued to tout the purported growth in

Merge DNA’s subscription revenue backlog. For instance, Merge highlighted in the October 30,

2013 Press Release the alleged 73% growth in its subscription revenue backlog since the third

quarter of 2012, including a “$29.5 million (127%)” increase in Merge DNA’s subscription

revenue backlog.

153. On January 8, 2014, Defendants admitted for the first time that the subscription

revenue backlog figures that the Company had been reporting to the market throughout the Class

Period were overstated. Before the market opened on that date, Defendants disclosed “that a

former sales employee in [Merge’s] eClinical business had falsified the existence or amount of

certain customer contracts” during the six quarterly periods ending June 30, 2012 through

September 30, 2013. Defendants also revealed that during these six quarters, Merge DNA’s

reported subscription revenue backlog was overstated by more than $15 million, including, inter

alia, more than $5.3 million and $4.3 million in falsified bookings during the fourth quarter of

49


2012 and second quarter of 2013, respectively. Defendants further disclosed that the individual

who falsified the contracts did so “in order to achieve sales quotas and receive additional

commissions,” and resigned in September 2013. Moreover, Defendants signaled to investors

that Merge’s internal controls were materially deficient, disclosing that:

For calendar year 2013, and prior to the discovery of this issue, the [C]ompany had modified its compensation plans for its eClinical sales personnel from a plan that was primarily based on contract signings to one that is driven by customer invoicing and cash collections. The [C]ompany’s senior management has identified, and its Board of Directors has adopted, other modifications to the [C]ompany’s internal controls to strengthen its processes for logging customer contracts and calculating commission for its sales personnel.

154. On this news, Merge’s common stock price fell an additional $0.41 per share,

from a close of $2.52 on January 7, 2014 to close at $2.11 per share on January 9, 2014 – a two-

day decline of approximately 16.3%.

155. Between August 8, 2013 and January 9, 2014, the price of Merge’s common stock

declined by 53%, thereby erasing nearly $225 million in market capitalization from the

Company.

VIII. THE FRAUD-ON-THE-MARKET DOCTRINE APPLIES

156. At all relevant times, the market for Merge’s common stock was an efficient

market for the following reasons, among others:

a. Merge’s stock met the requirements for listing, and was listed and actively traded on the NASDAQ, a highly efficient electronic stock market;

b. As a registered and regulated issuer of securities, Merge filed periodic public reports with the SEC, in addition to the Company’s frequent voluntary dissemination of information;

c. Merge regularly communicated with public investors via established market communication mechanisms, including regular disseminations of press releases on the national circuits of major newswire services and other wide-ranging public disclosures, such as communications with the financial press and other similar reporting services;

d. Merge was followed by securities analysts employed by major brokerage firms who wrote reports which were distributed to the sales force and

50


certain customers of their respective brokerage firms. Each of these reports was publicly available and entered the public marketplace;

e. The material misrepresentations and omissions alleged herein would tend to induce a reasonable investor to misjudge the value of Merge stock; and

f. Without knowledge of the misrepresented or omitted facts, Lead Plaintiff and the other members of the Class purchased or otherwise acquired Merge stock between the time that Defendants made the material misrepresentations and omissions and the time that the truth was revealed, during which time the price of Merge stock was artificially inflated by Defendants’ misrepresentations and omissions.

157. As a result of the foregoing, the market for Merge common stock promptly

digested current information regarding Merge from all publicly available sources, and the prices

of Merge common stock reflected such information. Based upon the materially false and

misleading statements and omissions of material fact alleged herein, Merge common stock

traded at artificially-inflated prices during the Class Period. Lead Plaintiff and the other

members of the Class purchased Merge common stock relying upon the integrity of the market

price of Merge common stock and other market information relating to Merge.

158. Under these circumstances, all purchasers of Merge common stock during the

Class Period suffered similar injuries through their purchases of Merge common stock at

artificially-inflated prices, and a presumption of reliance applies.

IX. THE STATUTORY SAFE HARBOR IS INAPPLICABLE

159. The statutory safe harbor provided for forward-looking statements under certain

circumstances does not apply to any of the allegedly false statements pleaded in this Complaint.

Many of the specific statements pleaded herein were not identified as “forward-looking

statements” when made. To the extent there were any such forward-looking statements, there

was no meaningful cautionary language identifying important factors that could cause actual

results to differ materially from those set forth in the purportedly forward-looking statement.

51


160. Alternatively, to the extent 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 knew that the particular forward-looking statement was false, and/or the forward-looking

statement was authorized and/or approved by an executive officer of Merge who knew that those

statements were false when made.

X. CLASS ACTION ALLEGATIONS

161. Lead Plaintiff brings this action as a class action pursuant to Federal Rules of

Civil Procedure 23(a) and 23(b)(3) on behalf of itself and all those who purchased Merge

common stock during the Class Period. Excluded from the Class are Defendants, members of

Defendants’ immediate families, any person, firm, trust, corporation, officer, director, or other

individual or entity in which any Defendant has a controlling interest, or which is related to or

affiliated with any of Defendants, and the legal representatives, agents, affiliates, heirs,

successors-in-interest, or assigns of any such excluded party.

162. The members of the Class are so numerous and geographically dispersed that

joinder of all members is impracticable. At the end of the Class Period, approximately 96.6

million shares of Merge common stock were outstanding and actively traded on the NASDAQ.

The precise number of Class members is unknown to Lead Plaintiff at this time, but is believed

to be in the hundreds, if not thousands. In addition, the names and addresses of the Class

members can be ascertained from the books and records of Merge or its transfer agent. Notice

can be provided to such record owners by a combination of published notice and first-class mail,

using techniques and a form of notice similar to those customarily used in class actions arising

under the federal securities laws.

52


163. Lead Plaintiff will fairly and adequately represent and protect the interests of the

other members of the Class. Lead Plaintiff has retained competent counsel experienced in class

action litigation under the federal securities laws to further ensure such protection and intends to

prosecute this action vigorously.

164. Lead Plaintiff’s claims are typical of the claims of all other members of the Class

because Lead Plaintiff’s and all of the other Class members’ damages arise from, and were

caused by, the same false and misleading representations and omissions made by, or chargeable

to, Defendants. Lead Plaintiff does not have any interests antagonistic to, or in conflict with, the

Class.

165. A class action is superior to other available methods for the fair and efficient

adjudication of this controversy. Since the damages suffered by individual Class members may

be relatively small, the expense and burden of individual litigation make it virtually impossible

for Class members to seek redress for the wrongful conduct alleged. Lead Plaintiff knows of no

difficulty that will be encountered in the management of this litigation that would preclude its

maintenance as a class action.

166. Common questions of law and fact exist as to all members of the Class and

predominate over any questions solely affecting individual members of the Class. Among the

questions of law and fact common to members of the Class are:

a. whether the federal securities laws were violated by Defendants’ acts as alleged herein;

b. whether Defendants’ statements issued during the Class Period were materially false and misleading; and

c. the extent of injuries sustained by members of the Class and the appropriate measure of damages.

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XI. CAUSES OF ACTION

COUNT I

For Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated Thereunder Against All Defendants

167. Lead Plaintiff incorporates by reference and realleges all preceding paragraphs as

if fully set forth herein. This claim is asserted against all Defendants.

168. During the Class Period, Defendants used the means and instrumentalities of

interstate commerce, the U.S. mails, and the facilities of national securities exchanges to make

the materially false and misleading statements and omissions of material fact alleged herein to:

(i) deceive the investing public, including Lead Plaintiff and the other Class members, as alleged

herein; (ii) artificially inflate and maintain the market price of Merge common stock; and

(iii) cause Lead Plaintiff and the other members of the Class to purchase Merge common stock at

artificially-inflated prices that did not reflect their true value. In furtherance of their unlawful

scheme, plan, and course of conduct, Defendants took the actions set forth herein.

169. While in possession of material adverse, non-public information, Defendants,

individually and in concert, directly and indirectly, by the use of means and instrumentalities of

interstate commerce, the U.S. mails, and the facilities of national securities exchanges:

(i) employed devices, schemes, and artifices to defraud; (ii) made untrue statements of material

fact and/or failed to disclose material facts necessary to make the statements that they made not

misleading; and (iii) engaged in acts, practices, and a course of business that operated as a fraud

and deceit upon the purchasers of the Company’s common stock in an effort to maintain

artificially high market prices for Merge common stock, in violation of Section 10(b) of the

Exchange Act and Rule 10b-5 promulgated thereunder. All Defendants are sued as primary

participants in the wrongful conduct alleged herein.

54


170. By virtue of their high-level positions at the Company during the Class Period, the

Individual Defendants were authorized to make public statements, and made public statements

during the Class Period on Merge’s behalf. The Individual Defendants were privy to and

participated in the creation, development, and issuance of the materially false and misleading

statements alleged herein, and/or were aware of the Company’s and their own dissemination of

information to the investing public that they recklessly disregarded was materially false and

misleading.

171. In addition to the duties of full disclosure imposed on Defendants as a result of

their making of affirmative statements and reports to the investing public, Defendants had a duty

to promptly disseminate truthful information that would be material to investors in compliance

with the integrated disclosure provisions of the SEC, as embodied in SEC Regulation S-X (17

C.F.R. Section 210.01 et seq .) and Regulation S-K (17 C.F.R. Section 229.10 et seq .), as well as

other SEC regulations, including accurate and truthful information with respect to the

Company’s operations, so that the market price of the Company’s common stock would be based

on truthful, complete, and accurate information. The Individual Defendants also had duties

under SOX to ensure that Merge’s Forms 10-Q and 10-K filed with the SEC did not misrepresent

or omit any material facts.

172. Defendants acted with reckless disregard for the truth of the misrepresented and

omitted facts alleged herein, in that they failed to ascertain and to disclose such facts, even

though such facts were readily available to them. Defendants’ material misrepresentations and

omissions were done recklessly, and had the effect of concealing the truth with respect to

Merge’s operations, business, performance, and prospects from the investing public and

supporting the artificially-inflated price of its common stock.

55


173. The dissemination of the materially false and misleading information and failure

to disclose material facts, as set forth above, artificially inflated the market price of Merge’s

common stock during the Class Period. In ignorance of the fact that the market prices of

Merge’s common stock were artificially inflated, and relying directly or indirectly upon the

materially false and misleading statements made by Defendants, and upon the integrity of the

market in which the Company’s common stock trades, or upon the absence of material adverse

information that was recklessly disregarded by Defendants but not disclosed in public statements

by Defendants during the Class Period, Lead Plaintiff and the other members of the Class

purchased Merge’s common stock during the Class Period at artificially-inflated prices. As the

truth eventually emerged, the price of Merge’s common stock substantially declined.

174. At the time of the material misrepresentations and omissions alleged herein, Lead

Plaintiff and the other members of the Class were ignorant of their falsity, and believed them to

be true. Had Lead Plaintiff and the other members of the Class and the marketplace known the

truth with respect to the business, operations, performance, and prospects of Merge, which was

concealed by Defendants, Lead Plaintiff and the other members of the Class would not have

purchased Merge’s common stock, or if they had purchased such securities, would not have done

so at the artificially-inflated prices that they paid.

175. By virtue of the foregoing, Defendants have violated § 10(b) of the Exchange Act,

and Rule 10b-5 promulgated thereunder.

176. As a direct and proximate result of Defendants’ wrongful conduct, Lead Plaintiff

and the other members of the Class suffered damages in connection with their transactions in the

Company’s common stock during the Class Period.

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COUNT II

For Violations of Section 20(a) of the Exchange Act Against the Individual Defendants

177. Lead Plaintiff repeats and realleges each and every allegation contained above as

if fully set forth herein. This claim is asserted against the Individual Defendants.

178. During the Class Period, the Individual Defendants were senior executive officers

and/or directors of Merge and were privy to confidential and proprietary information concerning

Merge, and its business, operations, performance, and future prospects, including its compliance

with applicable federal, state, and local laws and regulations.

179. Defendant Ferro served as a director and the Chairman of Merge’s Board of

Directors until August 26, 2013. Defendant Surges served as a director and the Company’s CEO

until August 5, 2013. Defendant Dearborn served as a director and the Company’s President at

all relevant times, and the CEO of Merge DNA until August 5, 2013, when he was appointed

CEO of the Company, effective August 8, 2013. Defendant Oreskovich served as the

Company’s CFO and Treasurer at all relevant times.

180. Because of their high-level positions at Merge, the Individual Defendants had

regular access to non-public information about its business, operations, performance, and future

prospects through access to internal corporate documents and information, conversations and

connections with other corporate officers and employees, attendance at management meetings

and meetings of the Company’s Board of Directors and committees thereof, as well as reports

and other information provided to them in connection therewith.

181. The Individual Defendants acted as controlling persons of Merge within the

meaning of § 20(a) of the Exchange Act, as alleged herein. By virtue of their high-level

positions, participation in, and/or awareness of the Company’s day-to-day operations, and/or

57


intimate knowledge of the statements filed by the Company with the SEC and disseminated to

the investing public, the Individual Defendants had the power to influence and control, and did

influence and control, directly or indirectly, the day-to-day decision-making of the Company,

including the content and dissemination of the various statements Lead Plaintiff alleges were

materially false and misleading. The Individual Defendants were provided with, or had

unlimited access to, copies of the Company’s reports, press releases, public filings, and other

statements alleged by Lead Plaintiff to have been misleading prior to and/or shortly after those

statements were issued, and had the ability to prevent the issuance of the statements and/or to

cause the statements to be corrected.

182. In particular, the Individual Defendants had direct and supervisory involvement in

the day-to-day operations of the Company, and therefore had, or are presumed to have had, the

power to control or influence the particular transactions giving rise to the securities violations as

alleged herein, and exercised the same.

183. As set forth above, the Individual Defendants and Merge violated § 10(b) and

Rule 10b-5 by their acts and omissions as alleged in this Complaint. By virtue of the Individual

Defendants’ positions as controlling persons, and their participation in the underlying violation

of § 10(b) and Rule 10b-5, the Individual Defendants are also liable pursuant to § 20(a) of the

Exchange Act. As a direct and proximate result of the Individual Defendants’ wrongful conduct,

Lead Plaintiff and the other members of the Class suffered damages in connection with their

purchases of the Company’s stock during the Class Period.

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WHEREFORE , Lead Plaintiff, on behalf of itself and the other members of the Class,

prays for relief and judgment, including:

A. Determining that Counts I and II of this action constitute a proper class action

under Federal Rules of Civil Procedure 23, certifying Lead Plaintiff as a Class representative

under Rule 23 of the Federal Rules of Civil Procedure, and certifying Lead Plaintiff’s counsel as

Lead and Liaison Counsel for the Class;

B. Awarding compensatory damages in favor of Lead Plaintiff and the other Class

members against all Defendants, jointly and severally, for all damages sustained as a result of

Defendants’ wrongdoing, in an amount to be determined at trial, including pre-judgment and

post-judgment interest, as allowed by law;

C. Awarding extraordinary, equitable, and/or injunctive relief as permitted by law

(including, but not limited to, rescission);

D. Awarding Lead Plaintiff and the other members of the Class their costs and

expenses incurred in this action, including reasonable counsel fees and expert fees; and

E. Awarding such other and further relief as may be just and proper.

JURY TRIAL DEMANDED

Lead Plaintiff hereby demands a trial by jury on all triable claims.

Dated: May 28, 2014 Respectfully Submitted,

LASKY & RIFKIND, LTD.

/s/ Norman Rifkind Norman Rifkind 351 West Hubbard Street, Suite 401 Chicago, IL 60654 Telephone: (312 634 0057 Facsimile: (312) 634-0059 [email protected]

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Liaison Counsel for Lead Plaintiff Arkansas Teacher Retirement System and the Class

KESSLER TOPAZ MELTZER & CHECK LLP Michael A. Yarnoff (admitted pro hac vice) Richard A. Russo, Jr. (admitted pro hac vice) Meredith L. Lambert (admitted pro hac vice) 280 King of Prussia Road Radnor, PA 19087 Telephone: (610) 667-7706 Facsimile: (610) 667-7056 [email protected] [email protected] [email protected]

Lead Counsel for Lead Plaintiff Arkansas Teacher Retirement System and the Class

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CERTIFICATE OF SERVICE

I hereby certify that on May 28, 2014, I electronically filed the foregoing with the Clerk

of the Court using the CM/ECF system. Notice of this filing will be sent to counsel of record by

operation of the Court’s electronic filing system.

I certify under the penalty of perjury under the laws of the United States of America that

the foregoing is true and correct. Executed on May 28, 2014.

/s/ Norman Rifkind Norman Rifkind

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