m. berne , osb no. 77407 , osb no . 95413 stoll stoll...

Gary M. Berne , OSB No . 77407Email : gberne@ssbls .comDavid F. Rees , OSB No . 95413Email : drees@ssbls .comMark A. Friel, OSB No . 00259Email : mfreil@ssbls .con-iSTOLL STOLL BERNE LOKTING & SCHLACHTER P .C.

209 S.W. Oak Street, Fifth FloorPortland, OR 97204Telephone : (503) 227-1600Facsimile: (503) 227-684 0

Lori G. Feldman (admitted pro hac vice)Email : Ifeldmangmilbergweiss .comMILBERG WEISS BERSHAD & SCHULMAN LLPOne Pennsylvania PlazaNeva York, NY 10119-0165Telephone: (212) 594-5300Facsimile : (212) 868-122 9

Co-Lead Counsel for Plaintiffs(Additional Plaintiffs' Counsel Listed on Signature Page )

IN THE UNITED STATES DISTRICT COURTFOR THE DISTRICT OF OREGO N

ZUCCO PARTNERS, LLC, REX BOGGS, Case No. CV 04-1390 BRKENNARD McADAM AND GLENNTHOMAS, on behalf of themselves and all CLASS ACTIONothers similarly situated ,

Plaintiffs, SECOND AMENDED CLASS ACTIONCOMPLAINT FOR VIOLATION O F

v. THE FEDERAL SECURITIES LAWS

DIGIMARC CORP ., BRUCE DAVIS, andE.K . RANJIT, JURY TRIAL DEMANDED

Defendants .

TABLE OF CONTENTS

Page

OVERVIEW OF THE ACTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

JURISDICTION AND VENUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0

THE PARTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0

FACTS UNDERMINING DEFENDANTS' CLASS PERIOD REPRESENTATIONS . . . . . . . . . . . . . . . 1 2

A. DEFENDANTS FALSELY PORTRAYED DIGIMARC'S CLAS SPERIOD PROFITABILITY AND GROWTH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2

1) Improper Capitalization of Inventory and Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . .720

2) Improper Capitalization of Purported Internal Software Developmen t

Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1

B . DEFENDANTS FALSELY PORTRAYED DIGIMARC'S FUTUR E

PROFITABILITY AND GROWTH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

DEFENDANTS' FALSE AND MISLEADING STATEMENTS DURING THE CLAS S

PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 9

A. FALSE STATEMENTS REGARDING DIGIMARC'S FIRST QUARTER2003 FINANCIAL RESULTS AND EXPECTED RESULTS FOR FUTURE

PERIODS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39

B . FALSE STATEMENTS REGARDING DIGIMARC'S SECOND QUARTE R2003 FINANCIAL RESULTS AND EXPECTED RESULTS FOR FUTUR E

PERIODS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42

C . FALSE STATEMENTS REGARDING DIGIMARC'S THIRD QUARTE R2003 FINANCIAL RESULTS AND EXPECTED RESULTS FOR FUTURE

PERIODS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46

D . DEFENDANTS' FALSE STATEMENTS REGARDING DIGIMARC' S

2003 YEAR-END FINANCIAL RESULTS AND EXPECTED RESULT S

FOR FUTURE PERIODS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

E. FALSE STATEMENTS REGARDING DIGIMARC'S FIRST QUARTER2004 FINANCIAL RESULTS AND EXPECTED RESULTS FOR FUTURE

PERIODS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56

F. DEFENDANTS' FALSE STATEMENTS REGARDING DIGIMARC' S

INTERNAL ACCOUNTING CONTROLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58

i

DEFENDANTS REVEAL DIGIMARC' S TRUE PRECARIOUS FINANCIA L

CONDITION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69

DEFENDANTS' FINANCIAL STATEMENTS DURING THE CLASS PERIO DWERE MATERIALLY FALSE AND MISLEADING AND VIOLATED GAAP . . . . . . . . . . . . . . . . . . . . . . .85

A. DIGIMARC'S IMPROPER CAPITALIZATION OF INTERNALL YDEVELOPED SOFTWARE COSTS AND IMPROPER PROJEC T

ACCOUNTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

B. DIGIMARC'S EXCESS, OBSOLETE AND SLOW MOVING INVENTORY . . .89

C. DIGIMARC'S FALSE AND MISLEADING FINANCIAL STATEMENTS

WERE MATERIAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 1a

D . DEFENDANTS' VIOLATIONS OF SEC REGULATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .94

ADDITIONAL SCIENTER ALLEGATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .95

A. INDIVIDUAL DEFENDANTS' CONSCIOUS BEHAVIOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .95

B . INSIDER TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .102

C . ENTRENCHMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .103

D. RAISING CAPITAL THROUGH A PRIVATE PLACEMENT OFFERING . . . . . 10 5

E. CORPORATE SCIENTER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105

INAPPLICABILITY OF THE STATUTORY SAFE HARBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109

GROUP PLEADING AND CONTROL PERSON ALLEGATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 9

CLASS ACTION ALLEGATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 2

APPLICABILITY OF PRESUMPTION OF RELIANCE : FRAUD-ON-THE-MARKE T

DOCTRINE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 4

COUNT IFOR VIOLATIONS OF SECTION 10(b) OF THE EXCHANGE ACT AN D

RULE lOb-5 PROMULGATED THEREUNDER AGAINST ALL DEFENDANTS . . . . . . . . . . . . . . . . 11 6

COUNT IIFOR VIOLATIONS OF SECTION 20(a) OF TIIE EXCHANGE ACT AGAINST

INDIVIDUAL DEFENDANTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 1

PRAYER FOR RELIEF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .122

JURY DEMAND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .123

11

Plaintiffs make the following allegations, except as to allegations specifically pertaining t o

Plaintiffs and Plaintiffs ' counsel, based upon the investigation undertaken by Plaintiffs' counsel ,

which investigation included interviews of knowledgeable witnesses, analysis of news article s

and reports, public filings, press releases and other matters of public record .

OVERVIEW OF THE ACTION

This is a securities class action on behalf of all persons who purchased o r

otherwise acquired the publicly traded securities of Digimarc Corporation ("Digimare" or th e

"Company") during the period of April 22, 2003 through July 28, 2004, inclusive (the "Clas s

Period") under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 ("Exchang e

Act"), and the regulations promulgated thereunder by the Securities and Exchange Commissio n

("SEC"), including Rule I Ob-5 .

2. As discussed in more detail below, Defendants issued, or caused to be issued, fals e

and misleading statements during the Class Period to artificially inflate the value of Digimarc

stock. Defendants' accounting manipulations created the illusion that Digimarc was a growing

and profitable company throughout the Class Period . In reality, and undisclosed to the market,

Digimarc was a company with out-of-control expenses, substantial losses, and woefull y

inadequate internal controls . After the Class Period, Defendants admitted that they issued fals e

financial reports and that the substantial majority of the reported income for the Company during

the Class Period was improper .

3. Specifically, Defendants admitted that they improperly boosted Digimarc' s

reported gross margins and profits by failing to expense approximately $2 .7 million worth of

ordinary expenses and improperly capitalizing these expenses as software development or projec t

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STOLL STOLL BERNE LOKTING & S}[LACI fl LR P .C .209 S .W. OAK STREET

PORTLAND, OREGON 97204TEL. (503) 227-1600 S'AX (503) 227-6840

development costs . Defendants manipulated Diginnare's reported financial statements by (a)

improperly capitalizing ordinary expenses as purported software development costs, (b)

improperly capitalizing ordinary expenses as purported project development costs, and (c)

improperly capitalizing obsolete or nonexistent inventory and fixed assets, all of which had the

effect of hiding or deferring costs the Company was incurring and was required to recognize .

These manipulations were accomplished by (a) purposefully recording costs in the wron g

accounts so that those costs could be capitalized rather than expensed, (b) instructing employees

to bill time to projects they were not working on so that Digimarc's payroll expense could b e

capitalized improperly, (c) reducing inventory reserve charges and "munging" inventory data t o

reduce the Company's reported costs of goods sold , and (d) keeping millions of dollars of

obsolete and impaired inventory on Digimarc's balance sheet .

4 . These allegations are supported by the accounts of former employees (includin g

Defendants' admissions of which these former employees have knowledge) and the admissions

included in Digimarc's significant restatement of its previously reported financial results (the

"Restatement") announced after the Class Period . By failing to recognize ordinary expenses

incurred by the Company and capitalizing ordinary payroll costs that Digimarc paid to its

software engineers and other employees, Defendants enabled the Company to improperly avoi d

recognizing these expenses on its income statements . These allegations are detailed below i n

¶11 45-64 ("Improper Capitalization of Inventory and Fixed Assets") and 1111 65-76 ("Imprope r

Capitalization of Purported Internal Software Development Costs" )

5. The false and improper capitalization of ordinary expenses and manipulation o f

reported inventory and costs of goods and expenses do not occur accidentally, and are strongly


S"I'OLL, STOLL I3ERNE LOKTING & SEILACHTER RC .209 S . W . OAK STREET

PORTLAND, OREGON 97204TEL. (503) 227-1000 LAX ( 503) 227-0840

indicative of intentional fraud . As detailed below, Defendants, Digimarc's top officers - CEO

Bruce Davis and CFO E.K. Ranjit - knew or were deliberately reckless regarding the improper

practices alleged . The nature and amount of the accounting manipulations were sufficient to

demonstrate scienter . Notably, Defendants violated several of their own "critical accounting

policies" during the Class Period. Confidential Witnesses corroborate plaintiffs' allegations that

key management and the Individual Defendants knew of the improper manipulations . For

example, former employees of Digimarc confirmed that Digimarc purposefully booked ordinary

expenses into the wrong expense accounts so that these expenses could be capitalized, thereby

boosting reported earnings throughout the Class Period . Moreover, former employees establish

that Defendant Ranjit ordered the elimination of critical accounting controls over capitalized

payroll, which enabled Digimarc's finance department to manipulate capitalized payroll accounts .

In their Restatement, Digimarc has admitted that, quarter after quarter during the Class Period, the

Company improperly capitalized highly material amounts of ordinary payroll expense .

6. Digimarc's primary business and source of revenues comes from contracts t o

provide drivers license issuance systems to state departments of motor vehicles . During the Clas s

Period, Digimarc's "ID Systems" business unit (which encompasses its drivers license business )

accounted for approximately 89% of the Company' s revenues . Typically, Digimarc enters into

contracts with states whereby the Company is paid a fixed amount per document issued .

Digimarc provides all of the equipment, hardware, software, inks, laminates, adhesives and on-

going support needed to issue the drivers licenses .

7. During the Class Period, the Company's primary costs for the provision of driver s

license issuance services and generation of revenues consisted of the cost of software developers ,


STOLL STOLL BERNE LOKT[NG & SHLACIITER P.C.

209 S .W . OAK STREET

T'OR'TLAND, OREGON 9720 4TEL. (503) 227-1600 FAX (503) 227-6840

quality assurance personnel, product managers and field operations. The Company was also

incurring millions of dollars of research and development costs to pay software development

personnel and outside contractors to develop new techniques and keep up with its competitors .

Generally Accepted Accounting Principles ("GAAP") require Digimarc to expense these costs of

services and research and development in the period they were incurred . As Digimarc has now

admitted, Defendants were erroneously capitalizing (rather than expensing) material amounts

of these ordinary expenses , which had the effect of boosting Digimarc's reported incom e

throughout the Class Period.

8 . In its Restatement, Digimarc admitted that the Company capitalized as "internal

software development costs" ordinary payroll and other expenses that had nothing to do .with the

development of internal software . According to a former Digimarc employee, Digimarc's senior

management, at the direction of Defendant Ranjit, instructed employees to bill time to projects on

which they were not working to enable the Company to capitalize and avoid expensing payroll

expenses that were required to be expensed . Another former employee explained that, during the

Class Period, the Company (again at Ranjit's direction) purposefully eliminated mid-level

managerial oversight of capitalization of payroll expenses and created an override function in its

project tracking software so that financial department personnel could enter changes and increase,

the amount of payroll expense that was capitalized over and above what employees entered into

the system. According to yet another former Digimarc employee, at the close of the first quarter

of 2003, Defendant Ranjit ordered financial personnel to make last minute journal entries to

increase the amount of payroll capitalized and enable the Company to meet analyst expectations

and report its first ever profit as a public company .


STOLE . STOLE . BF_.RNE: LOKTING & SHLACHTER P .C .209 S .W. OAK STREE T

PORTLAND, OREGON 9720 4

TEL . (503) 227-1600 FAX (503) 227,6040

9 . Digimarc is also required to keep track of millions of dollars of inventory ,

including its hardware, cameras, inks, laminates and adhesives . GAAP requires Digimarc to

expense inventory that was consumed in its production process as it issued drivers licenses, and to

take expense charges to write-down obsolete inventory . Defendants manipulated inventory levels

and improperly capitalized inventory and fixed assets . These allegations are also corroborated by

several Confidential Witnesses. According to several former Digimarc employees, throughout

the Class Period, Digimarc had no accurate system for tracking its inventory and did not kno w

how much of its consumable inventory was being used in its issuance of drivers licenses .

According to former employees, Digimarc used frequent physical inventories to track its

consumption of inventory and then manipulated the results of these physical inventories to boos t

the amount of inventory on Digimarc's publicly reported balance sheets and to reduce the amount

of expenses recognized on Digimarc's publicly reported income statements . Former Digimarc

employees also confirmed that, throughout the Class Period, Digimarc kept millions of dollars of

obsolete and impaired inventory on its balance sheet . Defendants knew or recklessly disregarded

the fact that the Company was carrying millions of dollars of worthless or highly overvalued

inventory and property on its balance sheet, much of which had been sitting idle in Digimarc's

warehouses for several years. In addition, at Defendant Ranjit's direction, Digimarc purposefully,

reduced inventory reserve charges that were necessary to account for inventory that is scrapped 7r

lost in the production process . These inventory reserve charges were reduced so that Digimarc

could meet the unrealistic earnings estimates it provided to the market .

10. There was nothing inadvertent about Defendants' later-admitted accounting errors .

Defendants extracted Digimarc's key accounting data from the Company's integrated accountin g


STOLL STOLL BERNE I,OKTING & SH LACI]TER P .C .209 S . W. OAK STREE T

PORTLAND, OREGON 9720 4TEL . (503 ) 227.1600 VAX ( 503) 227-6840

system and put the data into a separate Excel spreadsheet prior to the close of every quarterly

accounting period. This was done so that Defendants could manipulate Digimarc's financial

results at the end of the quarter and falsely boost the Company's reported earnings in order to

meet market earnings expectations during the Class Period - expectations created by Defendants '

public estimates and statements to investors .

11 . In admitting that the Company improperly . -failed to expense approximately $2 .7

million worth of ordinary expenses, Defendants also admitted they improperly placed or retained

expenses on the Company's balance sheets as purported inventory, or purported property an d

equipment, directly contrary to Digimarc's publicly disclosed accounting policies and in violatio n

of GAAP . '

12. Defendants' manipulation of Digimarc's financial reports issued during the Clas s

Period was highly material, as set forth below, since the Company's fraudulent reporting resulte d

in significant restatements of net income once Digimarc revealed its "true" numbers :

TIME ORIGINALLY RESTATED AMOUNT O FPERIOD REPORTED INCOME OVERSTATE D

INCOME INCOM E

LOSS (LOSS )

Q1 2003 $29,000 ($150,000) $179,000

I The Company announced in an April 5, 2005 press release that the "collective earning .impact of prior period restatements was to increase the Company's reported net loss over theaffected periods by $2 .0 million" and that the collective impact of the restatement waspurportedly smaller than the amount of improper income reported in the Class Period .Defendants' portrayal was an effort to cover up Digimarc's accounting manipulations during theClass Period, as the Company relieved its balance sheet of false assets from prior periods when itreported its second quarter of 2004 results . The loss for this period, which was originally

reported as $1 .94 million after the close of the Class Period, was restated to a loss of $1 .27

million .


STOLL STroLL ERNE LOKTING & SHLACE II ER P .C .209 SAY . OAK STREET

POR'T'LAND, OREGON 97204TEL. (503) 227-1600 FAX(503)227-6W

Q2 2003 $287,000 $96,000 $191,00 0

Q3 2003 $1,284 ,000 $842,000 $442,000

Q4 2003 ($70,000) ($613,000) $543,00 0

2003 $1,530,000 $175,000 $1,355,00 0FULL YEAR TOTA L

Q1 2004 $525,000 ($786,000) $1,311,00 0

TOTAL $2,055,000 ($61 1 ,000) $2 ,666,00 0

13 . Defendants Ranjit and Davis personally certified to the market that Digimare ha d

adequate controls over its financial reporting and that they personally evaluated the effectiveness

of these controls . Defendants now admit that these certifications were false and that Digimarc's

accounting controls that were in place during the Class Period had "material weaknesses ."

Specifically, Defendants have now admitted that Digimarc's accounting and finance department

lacked supervision and expertise, that they failed to train accounting personnel how to operate a

new accounting system implemented during the Class Period and, critically, that there were

inadequate controls for determining the nature and types of costs that should be capitalized . In

fact, Defendants admitted they lacked the required documentary support for capitalization of

purported internal software development expenses, that there were inadequate controls over the

quarterly and year-end financial statement close process, and that their accounting system allowed

for unauthorized journal entries allowing for improper manipulation of Digimarc's financial

statements . Thus, the lack of internal controls and Defendants' false certifications of the

adequacy of internal controls is directly linked to Digimarc's materially false and misleading

financial statements issued during the Class Period . Notably, as set forth below, Defendants'

certifications themselves demonstrate their knowledge of material changes to Digimarc's interna l


STOI.A. STOLL BERNE LOKTING & S1HLACHTER P .C .

209 S .W . OAK STREE TPORTLAND, OREGON 9720 4

TEL . (503) 227-1600 FAX (503) 227-6840

accounting controls while at the same time Defendants provided false assurances to the market

that any changes were not significant .

14 . Defendants also issued materially misleading and false statements regarding

Digimarc's future revenue and earnings throughout the Class Period . In that regard, Defendants

publicly represented the Company's estimated revenue and earnings growth throughout 2003 and

2004 without any reasonable basis, as those estimates were inconsistent with the internal forecasts-

made by Digimarc's forecasting personnel. As discussed below, Digimarc's senior managemen t

repeatedly "adjusted" internal forecasts, deceptively adding revenues and subtracting expenses

from these internal forecasts, before publicly disclosing Digimare's earnings expectations so that

the market would perceive that the Company's business and profits were growing . A former

employee characterized management's improper manipulation of forecasts as "malicious ."

Defendants also failed to disclose the seasonality of drivers license issuances, which accounted

for the vast majority of Digimarc's revenues, and forecasted quarter over quarter revenue growth

even though it was well known within the Company that revenues would drop off precipitously in

the fourth quarter of every year .

15 . Defendants' fraudulent accounting practices and unrealistic earnings projection s

had their intended effect : the artificial inflation of Digimarc's stock price throughout the Class

Period. Thus, Defendants were able to create the false appearance throughout the Class Period

that Digimarc was a successful company with growing profits . Defendants Davis and Ranjit took

advantage of this by obtaining performance bonuses, including stock option grants, and unloading

a substantial amount of their personal stock holdings in the Company at inflated prices during the

Class Period. Davis, in fact, negotiated a new compensation package with the Company during

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STOLL SrOLL BERNIE LOKTING & S1 [LACHTH[t P .C.249 S .W . OAK STREET

PORTLAND, OREGON 9720 4TEL . (503) 227-1600 FAX (503) 227-6840

the Class Period and received a substantial performance bonus based in large part on Digirnarc's

falsely reported financial performance . The Company completed a $27 million private placement

offering based on its inflated stock price .

16. Digimarc abruptly announced the "retirement" of CFO Ranjit in February 2004, a

few months before the Company's disclosure of its improper accounting and lack of financial

controls which led to the Restatement .

17 . On July 28, 2004, the market learned the truth about Digimarc's precariou s

financial and operational condition : Digimarc had grossly inadequate financial controls and

substantial and growing losses . On that day, Digimarc announced that it was not going to meet

the Company's prior earnings projections because expenses were substantially higher than

expected and Digimarc had excessive amounts of obsolete inventory that needed to be written off .

This revelation about the true (and bleak) state of the Company's performance problems caused

the price of Digimarc stock to lose 25% of its value in a single day .

18. A few months later, on September 13, 2004, Digimarc further revealed that it had

previously filed false financial statements and failed to recognize material amounts of costs and

expenses throughout the Class Period . However, only general details were disclosed about the

Restatement would follow .

19. Additional details regarding the Restatement were disclosed seven months later

when the Company issued a more detailed restatement of its Fiscal Year 2003 and first two

quarters of 2004 financial results on April 7, 2005 . The Company admitted that its financial

results that were reported during the Class Period were overstated by approximately $2 .7 million

and that the Company had material internal financial control problems .


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PORTLAND, OREGON 97204TLL. (503) 227-1600 FAX (503) 227-0540

JURISDICTION AND VENU E

20 . This Court has jurisdiction over the subject matter of this action pursuant to § 2 7

of the Exchange Act (15 U .S .C. § 78aa) and 28 U .S .C. § 1331 . The claims asserted herein aris e

under Sections 10(b) and 20(a) of the Exchange Act, 15 U .S .C. § 78j(b) and 78t(a), and the rule s

and regulations promulgated thereunder by the SEC, including Rule IOb-5 (17 C .F .R. § 240.1 Ob-

5) .

21 . Venue is proper in this district pursuant to Section 27 of the Exchange Act (28

U .S.C. § 1391(b)) . Many of the acts and transactions giving rise to the violations of law

complained of herein, including the preparation and dissemination to the investing public of fals e

and misleading information, occurred in this district . In addition, Digimarc maintains it s

principal executive offices in this District .

22. In connection with the acts, conduct and other wrongs complained of herein ,

Defendants used the means and instrumentalities of interstate commerce, including the mails ,

telephone and the facilities of national securities exchanges .

THE PARTIE S

23. The Court-appointed Lead Plaintiffs Rex Boggs, Kennard B . McAdam, and Glen n

Ellen Thomas purchased Digimarc common stock during the Class Period, as evidenced by th e

certifications attached hereto .

24 . Defendant Digimarc is a Delaware corporation currently headquartered at 940 5

SW Gemini Drive, Beaverton, Oregon . Throughout the Class Period , it was based in Tualatin,

Oregon, moving to Beaverton in September 2004. The Company 's website provides the

following description of its operations :


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PORTLAND, OREGON 97204TE L . (503) 227-1000 FAX (503) 227-6840

Digimarc Corporation (NASDAQ :DMRC), based in Beave rton , Oregon, is aleading supplier of secure identity and media management solutions . Digimarc

provides products and services that enable the production of more than 60 millionpersonal identi fication documents, including two -thirds of the U.S . dr iver licenses

and IDs for more than 20 countries . Digimarc 's digital watermarking technologyprovides a persistent digital identity for various media content and is used toenhance the security of financial documents, identity documents and digitalimages, and support other media rights management applications .

Digimarc has an extensive intellectual property portfolio, with more that

200 issued U .S . patents with more than 4,000 claims, and more than 400 pending

patent applications in digital watermarking, personal identification and related

technologies .

The Company is headquartered in Beaverton, Oregon, with other U.S .

offices in Burlington, Massachusetts ; Fort Wayne, Indiana; and the Washington

DC area; and international offices in London and Mexico .

25 . Defendant Bruce Davis ("Davis") is, and was at all relevant times, Digimarc' s

Chief Executive Officer (since December 1997) and Chair of Digimarc's Board of Directors

(since May 2002) . Davis entered into an employment agreement with Digimarc effective July 16,

2001, although Diginare has increased the amount of salary and bonus paid to Davis above what

is set forth in his employment agreement. Davis was paid $472,000 in 2003 in salary and bonus .

Significantly, Davis' bonus was based in part on Digimarc's "operating profit" in 2003, which

was based on Digimarc's fraudulent accounting practices . Davis sold 38,750 shares of Digimarc

stock at artificially inflated prices during the Class Period, pocketing proceeds of $610,375 .

Davis signed Digimarc's 2003 Form 10-K and all of Digimarc's Form. 10-Qs issued during the -

Class Period and (falsely) certified these SEC filings pursuant to § 302 and 906 of the Sarbanes-

Oxley Act of 2002 ("Sarbanes-Oxley") . In addition, as set forth in detail below, throughout the

Class Period, Davis made numerous false statements in press releases and conference calls with

analysts about Digimarc's financial condition, outlook and accounting controls .


STOLL STOLL BERNE LOKTING & SHLACHTER P .C .

Z09 S .W . OAK STREE TPORTLAND, OREGON 9720 4

TEL . (503) 227-1600 FAX (503) 227-6840

26 . Defendant E.K. Ranjit ("Ranjit") was Chief Financial Officer and Treasurer of

Diginlarc from 1999 to May 2004. Although Digimarc publicly announced Ranjit's intention to

"retire" from Digimarc to "pursue other interests" on February 10, 2004, Ranj it's departure from

the Company is highly suspicious because it occurred just prior to the time the market learned

that Digimarc's financial reporting was in disarray and the Company was engaging in extensive

accounting fraud under Ranjit's direction and control. During the Class Period, Ranjit sold

30,000 shares of Digimarc stock at artificially inflated prices, pocketing proceeds of $392,750 .

Ranjit signed Digimarc's 2003 Form 10-K and all of Digimarc's Form I0-Qs issued during the

Class Period, and (falsely) certified these SEC filings pursuant to §§ 302 and 906 of Sarbanes-

Oxley. In addition, as set forth in detail below, throughout the Class Period, Ranjit made

numerous false statements in press releases and conference calls with analysts about Digimarc's

financial condition, outlook and accounting controls .

27 . Defendants Davis and Ranjit are referred to herein as the "Individual Defendants . "

FACTS UNDERMINING DEFENDANTS' CLASS PERIOD REPRESENTATION S

A. DEFENDANTS FALSELY PORTRAYED DIGIMARC'SCLASS PERIOD PROFITABILITY AND GROWT H

28 . Defendants' public statements during the Class Period touted Digimarc's turn t o

profitability and growing profits . For example, on April 22, 2003, the Company issued a pres s

release with the headline : "Digimarc Reports First Profitable Quarter As A Public Company ."

Defendant Ranjit was quoted in the April 22, 2003 release as saying : "Our financial performance

for the quarter was solid . . . [b]oth revenues and profits were within our guidance ." On July 22,

2003, the Company issued a press release quoting Defendant Ranjit as saying : "We reported a


STOL L STOLL BERNE LOKTING & SELACIITE R 1'-C.209 S .W . OAK STREET

PORTLAND , OREGON 97204TEL (503) 227-1600 FAX (503 ) 227-6840

second consecutive quarter of profitability that exceeded First Call earnings per share consensus

by I cent for the quarter ." On October 21, 2003, Digimarc issued a press release entitled,

"Digirarc Reports Third Consecutive Quarter of Improved Profitability . "

29. Contrary to Defendants' glowing statements about Digimarc's improving financial

performance, the reality was that - at all relevant times - Digimarc's costs were out-of-control

and Defendants were increasingly relying upon fraudulent accounting manipulations to maintain

the appearance that Digimarc was a successful, growing and profitable company that was meetin g

the market's expectations . To the contrary, Defendants have admitted that every one of its

financial statements issued during the Class Period violated GAAP, the accounting principles

recognized by the accounting profession as the conventions, rules, and procedures necessary to

define accepted accounting practice at a particular time . Confidential former employees of

Digimarc have provided detailed information on how the Individual Defendants directed the

improper accounting for expenses to boost Digimarc's reported earnings and deliberately

eliminated Digimarc's internal controls to facilitate the accounting fraud .

30. Confidential Witness No . 1 ("CW I"), worked at Digimarc throughout the Clas s

Period and was Director of the IT Department of Digimarc's ID Systems, reporting directly to

Defendant Ranjit . During the Class Period, CW I was made the Director of Supply Chain

Management at Diginnarc, and put in charge of managing Diginiarc's inventory and inventory

accounting. From the fall of 2002 until about May of 2004, CWl reported to Defendant Ranjit .

From May 2004 to about June 2004, CWI reported to Paul Gifford, former President and Chief

Operating Officer of Digimarc . CW1 worked extensively on Digimarc's accounting system

software, including Digimarc's implementation of a new accounting system in 2003 and 2004, the

Page 13 - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION O F

THE FEDERAL SECURITIES LAW

STOLL ST OLL BERN G [,OKTING & SHLACHTGR P .C .209 S.W . OAK STREET

PORTLAND, OREGON 9720 4TEL (503) 227-1600 FAX (503) 227-6840

"Great Plains" system, which was supposed to integrate all of Digimarc's accounting systems,

create reliable financial statements and allow Digimare to track inventory in an efficient and

accurate manner. CW1 also worked extensively trying to resolve Digirnarc's serious problem of

tracking and valuing its inventory . According to CW 1, the IT Department had knowledge about

the methodology used by Digimarc to count and track inventory, and knew that the methodology

developed by the IT Department (through the efforts of CW 1 and those under his/her supervision)

and utilized throughout the Great Plains accounting system, resulted in accurate inventory

numbers . Despite this fact, at Ranjit's direction CW 1 and those under his/her supervision in the

IT Department, set up "Access databases" to track Digimarc's inventory outside the Great Plains

system, and the senior management used these separate databases to generate the Company's

financial reports . As discussed in more detail below, these Access databases were easy to

manipulate and in fact were used by Defendants to generate false financial reports for the

Company during the Class Period . 2

31 . According to CWI, Defendant Ranjit was obsessed with meeting the market' s

earnings expectations for Digimarc . CWI explained that during the Class Period, at the close of

the quarterly accounting periods, Defendant Ranjit required the IT Department to take out all of

the data from Digimare's Great Plains integrated accounting system (and Digimarc's prior

integrated accounting system), and put the data into spreadsheets purportedly so senior

management (i .e . Ranjit and those who reported to him) could "analyze" the financial data before

closing the books for the quarter. According to CW1, the real purpose of this process was to

2 Certain of these Access databases were provided to plaintiffs' counsel . Plaintiffs'counsel thereafter delivered to them to the Court to retain for the parties in this litigation .


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PORTLAND, OREGON 9720 4TEL . (503) 227 .1600 FAX (503) 227-6840

allow Ranjit to determine what purported improper accounting "adjustments" were needed for th e

Company to meet analysts' earnings expectations .

32 . Confidential Witness No. 2 ("CW2"), worked at Digimarc throughout the majority

of the Class Period (leaving just shortly before the end of the Class Period), in the IT Department

of Digimarc's ID Systems . CW2 reported to CWI . CW2 also worked extensively on Digimarc's

implementation of Digimarc's Great Plains accounting system, and had direct knowledge of how

Digimarc accounted for its inventory during the Class Period . According to CW2, the I T

Department ran the IT system for Digimarc's accounting department, and, in his/her words,

"worked for accounting ." CW2 performed numerous program changes for the Company's

accounting department . For example, as discussed in more detail below, CW2 assisted in settin g

up the Access databases Defendants used to manipulate reported inventory . CW2 also wrote

programming code that eliminated accounting controls over the amount of payroll the Company

capitalized as purported software development costs. CW 1 also wrote programming code that

enabled finance department personnel to log into the capitalized payroll system and make

overriding changes to the amounts capitalized . The Company has now admitted that it

improperly capitalized material amounts of payroll expense every quarter during the Class Period .

33 . According to both CW1 and CW2, even though the Great Plains system was set u p

to track Digimarc ' s inventory , they were instructed by senior finance personnel who reported to

Ranjit to create separate Access databases tracking Digimarc's inventory outside the Great Plains

accounting system. According to CW1 , he/she was informed that this was necessary because the

Great Plains system was not working properly . However, it later became clear that the Great

Plains system was working properly, but that Ranjit and Davis simply did not like the results,



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PORTLAND, ORROON 97204TEL. (50S) 227-1600 FAX (503) 227-6840

which showed a much lower inventory value than Defendants desired, leading to much higher

costs that needed to be expensed as costs of goods sold . The higher cost of goods sold would

have required the Company to report lower earnings . Moreover, according to CW2, the separate

inventory databases were insecure and allowed for improper manipulation of inventory withou t

ready detection .

34 . . Confidential Witness No . 3 ("CW3"), was.a financial analyst in Digimarc's ID

Systems finance department from shortly after the start of the Class Period until the end of 2004 ,

and was there during Digimarc's Restatement process . CW3 reported to Rahoul Banerjea, former

Digimarc ID Systems Vice President of Finance . CW3 was involved in preparation of bid

proposals and worked closely with other finance department employees involved in creating

forecasts of Digimarc's financial performance, and project managers involved in managing

Digimarc's drivers license and identification programs . CW3 also worked extensively attempting

to resolve the Company's serious accounting problems regarding its inventory in 2004 .

35 . Confidential Witness No . 4 ("CW4"), was a manager in the ID Systems Human

Resources department until the latter part of 2002 . CW4 reported to John Munday, former

Digimarc ID Systems President . According to CW4, decisions about what to capitalize were

made either by highly-placed finance employees, or made by the corporate-level employees at

Digimarc and Digimarc ID Systems . According to CW4, there was a lot of interaction between

the Digimare ID Systems finance and the Digimarc corporate finance people, and the decisions on

what to capitalize were made at headquarters . Corporate personnel from Tualatin (headquarters)

were always there in the quarter-end closings, according to CW4, and the Chief Financial Office r


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PORTLAND, OREGON 9720 4TEL (503 ) 227-1600 FAX (503) 227-6840

at Digimarc, Ranjit, was always there at the end of every quarter during the period CW4 worke d

there,

36. Confidential Witness No . 5 ("CW5"), was the ID Systems Controller fo r

Digimarc, reporting to Ranjit, from December 2001 until mid-to late 2002. CW5 reported to

Defendant Ranjit . According to CW5, Digimarc's buying ID Systems from Polaroid (i n

December 2001) was akin to the minnow swallowing the whale . Digimarc was a very smal l

operation in Tualatin, and it bought a business of two hundred and fifty people . According to

CW5, there was a tremendous amount of emphasis on meeting quarterly expectations, and the

pressure to meet numbers came down from Davis to Ranjit . CW5 acknowledged that the bi g

problem with the ID Systems business was having inappropriate expenses billed against softwar e

programs .

37. CW5 explained how the system of billing employee's time worked at Digimarc

during his/her tenure and how he/she believed it operated after his/her departure based o n

discussions with former colleagues who still worked there . According to CW5, over the course o f

a given month, employees enter their time into a labor system against particular programs the y

worked on . For example, they might enter six hours on the State of Florida program, three hour s

on the State of New Jersey program, etc . The labor costs were kept in a separate system from

travel and expense reimbursements . CW5 heard after he/she left Digimarc, once or twice in mi X

2003, from finance people who were in the organization at the time, that some expenses no t

directly related to a program were charged to that program . AccDDrding to CW5, after people pu t

their hours into the system, the finance group took the hours and incorporated them into the

financial statements, but they could not capitalize any more than forty hours a week, because that


STOLI . ST'OI_I . BRRNE L,OKTING & SHLACFITER P .C .209 S . W . OAK STREET

PORTLAND, OREGON 97204TGI ... (503) 227-1600 FAX (503) 227-6840

is the maximum the employee is paid . Thus, people could not charge time. for more than 160

hours in a month or 520 hours in a quarter . However, if the person in charge, i .e . the Chief

Operating Officer of the division, is under pressure from his boss, Bruce Davis, to make the

quarter, he can easily instruct that any hours that are put into the system must be put up against a

particular program or contract, and not against administrative time or a research program, which

are not capitalized .

38 . CW5 further explained the effect of the billing on the Company's financia l

statements . If someone gets forty hours of pay in a week and he spends twenty hours working for

a state contract, he could put twenty hours against that . The result is, twenty hours is capitalized

and not expensed, but rather booked to the balance sheet in an asset account, and twenty hours of

payroll costs come off the profit and loss statement . However, if someone only worked twenty

hours, they might be (and, according to information available to CW5) told to bill for forty . After

CW5's departure from Digimarc, he/she had discussions with employees who still worked at the

Company, and heard that time was being changed and hours reassigned improperly, resulting in

more payroll expense being capitalized improperly as assets .

39. Confidential Witness No. 6 ("CW6''), was based in Fort Wayne, Indiana, and wa s

Vice President of Supply Chain Management at Digimarc ID Systems from 2002 until early 2005 .

From 2002 until late 2004, CW6 reported to Indraneel (aka "Indra") Paul, former President of -

Digimarc ID Systems . CW6 was involved in tracking inventory, and purchasing and distribution

of materials . CW6 observed that Digimarc had three or four CFO's for the ID business during

his/her tenure . The witness described how a former controller for the ID group, Susan Scacchi,

worked there (ID Systems) for only about six weeks, and that she said publicly that she wa s


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PORTLAND, OREGON 97204TEL . (503) 227-1600 FAX {503) 227-6840

leaving because her superiors, including Paul Gifford, then President and Chief Operating Officer

of Digimarc, asked her to do some things she believed were unethical .

40. According to CW6, Defendant Ranjit and Paul Gifford were generally i n

Burlington at the quarter close during the years 2002, 2003, and part of 2004. According to the

witness, Ranjit and Gifford would take the ID Systems numbers and "fine tune them" befor e

rolling them up into the corporate, reported figures .

41 . With respect to Digimarc's difficulties pertaining to capitalization, CW6

understood that some employees were improperly capitalizing their labor on contracts . It was the

witness' experience that all department managers had a lot of pressure to reduce their costs, an d

were taught that anything that could be capitalized would help reduce costs .

42 . With respect to Digimare's difficulties with inventory, per CW6, Digimarc ha d

trouble correctly reporting inventory because the finance group kept manipulating the unit of

measure on much of the product . For example, instead of listing 500 hundred rolls of a particular

laminate, they would change rolls to boxes or sheets, or they would change feet to rolls, which

would either inflate or deflate the numbers . Then CW6 and others would have to go out and

double check it . CW6 believed Defendants constantly manipulated the inventory for the past tw o

years, starting in 2003 . CW6 believed Defendants did not have a good handle on the inventor y

until July or August of 2004, but explained that accounting for the inventory really was not the -

problem; how Defendants reported it was .

43. CW6 also confirmed that there was obsolete inventory . The witness explained that

there was inventory on Digimarc's balance sheet that was seven or eight years old and had no t

been used . In 2004, Digimarc had instant Polaroid film that had a 1997 or 1996 date on it,


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PORTLAND, OREGON 972047 EL . (503) 227-1600 PAX (503) 227-6340

although it expires after six months . At that time, they had approximately .three hundred thousan d

dollars worth .

44. The accounts of former employees (including Defendants' admissions of whic h

these former employees have knowledge) and the admission included in Digimarc's Restatement

establish that Defendants used two primary accounting manipulations to deceptively bolster

Digimarc's financial condition during the Class Period, both of which had the effect of hiding or

deferring costs the Company was incurring and was required to recognize . The first manipulatio n

was the failure to recognize ordinary expenses incurred by the Company . Instead, Defendants

improperly moved or retained these expenses in Digimarc's inventory or property and equipment

accounts as purported "project development expenses ." The second manipulation was to,

capitalize on its asset balance sheet ordinary payroll costs that Digimarc paid to its software

engineers and other employees so that the Company could avoid recognizing these expenses on

its income statements. These two manipulations are addressed below in Jill 45-64 ("Improper

Capitalization of Inventory and Fixed Assets") and ¶¶ 65-76 ("Improper Capitalization of

Purported Internal Software Development Costs") .

1) Improper Capitalization of Inventory and Fixed Asset s

45 . By restating its previously filed financial statements issued during the Clas s

Period, Digimarc has admitted that it falsely recorded as inventory or fixed assets materia l

amounts of ordinary day-to-day expenses . In its Restatement set forth in its Form 10-K for th e

year ended December 31, 2004 ("2004 Form 10-K") and its Form 10-Q for the period ende d

September 30, 2004, the Company stated:


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Project Accounting Cost Tracking and Cost Deferrals . We erroneously trackedcosts for various projects as a result of certain difficulties we had implementing anew accounting system in late 2003 and early 2004 . As a result, certain costs thatshould have been recognized as expenses in the period incurred were erroneouslyrecorded as inventory or as fixed assets .

46. According to CWI, Digimarc purchased raw materials that went through several

production processes with numerous vendors before it was ready for use, and that each production

process resulted in a loss of some of the materials being processed (so called "scrap material") .

According to CW I, throughout the Class Period, Digimare used unreasonably low loss or scrap

assumptions in its projections of future results, and therefore its actual inventory value was

substantially lower than senior management expected throughout the Class Period . In fact, during

the spring of 2004, CW1 met with Rahoul Banerjea (Digimarc's former ID Systems Vice-

President of Finance) and a consultant for the Great Plains system regarding the proper scrap rate

that needed to be used in order to accurately reflect inventory . CWI informed Banezjea during

this meeting that the Company had a problem with "seriously overvalued inventory" and that the

Company was not accounting for scrap properly . According to CW 1 ; senior management at

Digimarc (including Valerie Ford and Ranjit) applied an across-the-board scrap rate of anywhere

between 5%-30% (which was included in the inventory reserve account), even though CW I

explained to Banerjea during this meeting that the scrap rates were often as high as 60% . CW1

knew this because he/she and those under his/her supervision had calculated the correct scrap

rates. In addition, according to CW 1, the Company's use of a single, across-the-board scrap rate

applied at the end of the manufacturing process resulted in inaccurate, underreported expenses

because scrap was created at each stage of the manufacturing process . The use of an incorrect

scrap rate had the effect of materially inflating inventory values and reducing costs of goods sold,


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PORTLAND, OREGON 97204TEL . (503) 227-1600 FAX (503) 227-6840

ultimately resulted in the false boosting of the Company's reported earnings . After the meeting

with Banerjea, CW1 had a conversation with senior management (including Ranjit, Indra Paul,

Paul Gifford, and the then Controller of Digimarc and the ID Systems business unit) about the

problems, and sent senior management an email detailing the inventory problems, including the

fact that the scrap rates should be applied at each stage of the manufacturing process and not onl y

to the end product .

47 . CW3 confirmed that Digimarc was also unable to properly value its inventory

during the Class Period because the Company had no basis to know how much to charge out of its

inventory when it produced drivers licenses and identification cards . According to CW3,

Digimarc had large discrepancies between what it expected to have in inventory and what its

actual inventory was because it was not removing the proper dollar amount of inventory as costs

of goods sold as it was producing drivers license and identification card projects .

48 . CW6 stated that Rahoul Banerjea was accessing Digimarc's inventory accounts o n

his own and manipulating the value of the Company's inventory to make it appear that the

Company had more inventory than it actually had . Then when Company personnel conducted

physical inventory counts, there was missing inventory . CW6 stated that he/she was aware that

there were several meetings between Banerjea, Ranjit, Val Ford and Paul Gifford in 2003 and

early 2004 where the Company's problems accounting for inventory, and issues resulting from

inventory manipulations were discussed. CW6 stated that by late 2003, the frequency of these

meetings increased and occurred every two weeks, and that Ranjit, Gifford and Ford were present

for all of these meetings . CW6 was present at some of these meetings, and even offered his/her

assistance to Banerjea and Ranjit to resolve the problems that Digimarc was having accounting



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PORTLAND, OREGON 97204

TEL. (503) 227-1600 PAX (503) 227-6340

for inventory, but Banerjea and Ranjit refused his/her offer. CW6 stated that, at the meetings,

Ranj it would ask specific questions regarding how often the Company needed to conduc t

inventories, how extensive the inventories needed to be, and whether the Company needed to

physically count its entire inventory . CW6 further explained that the Company simply did not

provide enough people or resources to properly address the Company's inventory accounting

problems . CW6 stated that Ranjit had to have known what was going on with respect to the

Company's inventory accounting manipulation .

49 . According to CW 1, the inventory scrap rate and valuation problems were less o f

an issue prior to the Class Period and early in 2003 because the Company took relatively large

inventory reserve charges every quarter to account for this variance between what the accounting

system showed for expense incurred in production and what expense was actually incurred .

However, per CW1, when pressure mounted to meet the market's earnings expectations in 2003

and 2004, the Company, at the direction of Defendant Ranjit, manipulated the inventory reserve

charges by significantly reducing the quarterly reserve charges in order to inflate their financials .

In fact, at the end of 2003, the Company had reduced its inventory reserves to $70,000 from

$330,000 at the end of 2002, and according to CWI, by the end of the first quarter of 2004, there

was very little left in the Company's inventory reserve account .

50. According to CW1 and CW2, in early 2004, Val Ford, the Controller of

Digimarc's ID Systems business unit who reported directly to Ranjit, instructed CW1 and CW2 to

create databases to track inventory separate from the Company's Great Plains accounting system .

According to CW 1, the separate Access databases were set up because Defendant Ranjit was

unhappy with numbers being generated by the Great Plains system (Digimarc's newly integrated



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PORTLAND, OREGON 9720 41E1L (503) 227-1600 FAX (503) 227-6840

accounting software system) because the Great Plains system reflected (accurately) much highe r

consumption of inventory during the production process, which would have resulted in lower

reported income for the Company .

51 . According to CW1, the Company conducted physical inventories on a monthl y

basis to track inventory. CW1 was involved (personally and through the direction of CW2 and

others) in conducting the physical inventory counts, validating the controls and entering the

numbers into the Great Plains and Access databases . According to CW 1, on a monthly basis

CW1 emailed inventory and scrap rate information, gathered by CW1 and those under his/her

supervision, to Indra Paul, CW6, Val Ford, and Ranjit . On several occasions, in response to

CW1's inventory report emails, Ranjit would contact him/her directly by telephone to talk about

the inventory numbers . According to CW I and CW2, Ford and other finance department

personnel munged the data in the separate Access databases at the end of the month, writing up

the value of the ending inventory to lower the Company's reported costs of goods sold and boost

its reported income . Critically, during this period, the first quarter of 2004, the Company's

accounting fraud peaked as the Company falsely boosted the inventory and equipment on

Digimarc's balance sheet and Digimarc's reported earnings by over $1 .1 million for this period .

52 . Beginning in January 2004, CW 1 attended monthly meetings held at Digimarc' s

Fort Wayne, Indiana, facilities with senior management during which issues of inventory control

and valuation were discussed . Defendant Ranj it attended roughly half of these meetings by

telephone or in person . On one occasion in particular, in or about April or May 2004, CW1 was

present at a meeting in Fort Wayne, Indiana, in which the issues of inventory, inventory

valuation, and the use of the Great Plains accounting system versus using separate databases to



STOLL STOLL. BGRNE LOKTINO & SHLACHTER P .C.



account for the inventory were discussed . The meeting lasted about an hour, and also in

attendance were Paul Gifford, Val Ford, CW6, and Defendant Ranjit . CW1 spent time explaining

to the group how Great Plains worked, and why the inventory numbers input into that system

were accurate . In addition to this meeting, on a separate occasion CW1 had a telephone call (in

the presence of Ranjit and Rahoul Banerjea) with a consultant from Microsoft regarding the Great

Plains system. This call took place at the desk of CW2 . During the call, CW 1 and the Microsoft

consultant walked through the process of how the inventory numbers were created in the Grea t

Plains system and confirmed that the numbers were correct .

53 . Despite the above-described presentation, and despite the conversation with the

Microsoft consultant, Ranjit and others asserted that they did not believe the numbers being

generated in the Great Plains system . CW l stated that the numbers generated in Great Plains

showed (accurately) a lower value for inventory and a correspondingly higher cost of goods sold

than Digimarc's financial statements . Ranjit and other members of senior management who

expressed disbelief in the inventory numbers did not state the basis for their asserted belief. In

fact, according to CW 1, the IT Department (through the Great Plains system that it set up and into

which the correct inventory data was input) was the ultimate source of the correct inventory

information, and there was no other reliable source from which Ranjit or anyone else could have

obtained accurate inventory numbers . Nonetheless, the Company continued to make use of the-

separate Access databases (which, unlike the Great Plains system, had no controls) to generate the

inventory figures used for the Company's financial statements . In fact, according to CWI, the

Company never closed its books through the Great Plains system, but instead used the numerous

Access databases created outside the Great Plains system . At the end of the quarter, CW I and



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those under his/her supervision took these numerous databases and rolled them into one single

database which was then given to Val Ford for use in preparing the Company's financials .

According to CWI, this enabled Defendants to manipulate the Company's reported inventory and

falsely boost the Company's reported income .

54 . At the meeting in Fort Wayne, Indiana described above, CW 1 also explained to

Ranjit and other members of senior management that the Company's actual scrap rates were

much higher than the Company's assumed scrap rates and this was why it appeared as if

inventory was disappearing . CW 1 explained that the balance sheet was not being relieved of

inventory consumed in production, and thus the costs-of-goods-sold expense charged against

earnings was too low. CW 1 calculated what the actual scrap rates were in preparation for thi s

meeting.

55 . CW3 worked closely with Claudia Rao , a former staff accountant at Digimarc's I D

Systems, who was in charge of booking expense entries . Rao told CW3 that Digimarc was

booking purchases to the wrong project so that the purchases could be capitalized, rather than

expensed, thereby improving the Company's bottom line . For example, if a certain purchase of

materials was incurred to service or maintain an existing drivers license program, such a purchase

could not be capitalized and was required to be expensed . Rao told CW3 that she was directed by,

senior management (who were directed by Defendant Ranjit) to improperly book such purchases

in an account for a drivers license program that was still in the implementation stage so that the

purchase expense could be capitalized and would not lower the Company's reported earnings .

This violated AICPA SOP 98-5 and contradicted the Company's publicly disclosed accounting

policy, which stated that the Company only capitalized pre-contract activities and only for th e


STOLE ST'OLL BERNE LOKTING & SELACHTER P .C .A9 S M . OAK STREE T


period after the contract was awarded. Digimarc's 2003 Form 10-K and Form 10-Qs issued

during the Class Period state :

Costs related to pre -contract activity are expensed as incurred inaccordance with the American Institute of Certified Public Accountants("AICPA") Statement of Position ("SOP") No . 98-5, Reporting on the Costs of

Start-Up Activities . The Company begins capitalizing costs when it receivesnotification that a contract will be awarded . 3

56. According to CW3, the Company improperly capitalized research and

development costs, or costs Digimarc incurred while researching potential new technologies and

materials . Capitalization of such research and development costs violated both GAAP and the

Company's own publicly disclosed accounting policy . PASS Statement of Standard No . 2

requires companies co expense research and development costs in the period the costs are incurred

because at the time such costs are incurred the future benefits of such expenses are at bes t

: .uncertain and there is no causal connection between such expenditures and specific future

revenue generation . The Company's SEC filings during the Class Period falsely stated that all

research and development costs were expensed in the period incurred . Digimarc has admitted

that it improperly capitalized approximately $627,000 of research and development expenses in

2003, accounting for more than 40% of Digimarc's falsely reported income in 2003 . CW3

stated that the Company's purported policy of expensing research and development costs wa s

"ridiculous," and that the Company routinely capitalized these expenses .

3 The Form I O-Qs filed during the Class Period contain identical language regardingDigimarc's capitalization of pre-contract a . tivity: the I0-Qs for the quarters ended March 31,2003, June 30, 2003, September 30, 2003, and March 31, 2004 .

Here, as elsewhere, all emphasis is added .

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STOU . S'IOI.%, BERNE LOK; , G & SHLACFI'1'ER P.C .209 S w . OAK STREET

PORTLAND, OREGON 97204'CEL.. (503) 227-1600 PAX (503) 227-6340

57 . CW3 further explained that Claudia Rao, the former ID Systems staff accountant ,

told him/her that research and development purchases and expenses were going into capital asset

accounts, but that these expenses were never coming out of the asset accounts because Rao was

never' instructed to begin amortizing these capitalized expenses . CW3 explained that the

Company had no tracking system to keep track of such capital expenses as they built up on the

Company's balance sheet, but rather only began amortizing such capital expenses when

management told Rao that the assets had become revenue generating and should be amortized .

CW3 related that Rao told him/her that she was never instructed to close out projects with

capitalized expenses and therefore the research and development expenses that were bein g

capitalized were improperly accumulating on the Company's balance sheet .

58. As part of his/her responsibilities as Director of Supply Chain management, CW 1

was placed in charge of investigating what overvalued or obsolete inventory Digimarc was

carrying on its books . According to CW1, the Company had completely inadequate internal

controls regarding the valuation of its inventory, notwithstanding Defendants' Class Period

representations and certifications to the contrary under Sarbanes-Oxley regarding its controls

(which are set forth in ¶ 124 below). For example, according to CW1, the Company had

approxin.ately $2 million in book value of cameras and laminate inventory in its warehouse that

was obsolete and substantially overvalued on the Company's balance sheet . Some of this

inventory had been sitting idle in warehouses for several years, according to CW1, who knew this

because, in early 2004 when he/she became Director of Supply Chain Management, he/she

reviewed inventory reports that showed the inventory remained there for several years .


STOLL s'COLL BERNF LOIc ;^ & SULACI ITER P .C.209 S W, OAK: uT EET

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59. Between April and June 2004, CWl had a number of discussions with senior

executives, including Defendant Ranjit, Rahoul Baneijea, Val Ford, and Indra Paul, to discuss the

serious problems Digimarc had with overvalued and obsolete inventory on its books . CW 1 also

informed senior management (including Paul, who reported to Ranjit) of these serious problems

by way of written report (which report had been prepared at the direction of Paul) . Senior

management responded that they were concerned enough already about making "our numbers,"

had no inventory reserves remaining, and looked to find a way to wait until a later quarter t o

disclose the long-obsolete inventory numbers . According to CW 1, a project accountant for the

Company, who had been employed by Polaroid when the ID Systems business unit was

purchased in late 2001, specifically told Ranjit in December 2001 about the cameras in inventory

at the time that were already obsolete, the total value of which at the time was roughly $240,000 .

These obsolete cameras were part of the $2 million or so in obsolete inventory about which CW I

informed senior management in the above described report . CWI knows this because the project

accountant relayed this conversation to CW 1 .

60. According to CWI, the Company's inventory controls were so weak that it had

approximately $130,000 of inventory value on its books for worthless laminate inventory that had

been in the Company's Missouri warehouse, but had been shredded. In other words, the

Company kept material amounts of value in its inventory account for worthless inventory that no

longer exis~.ed .

61 . According to CWI, when he/she raised the issue regarding the serious problem the

Company had with overvalued inventory around the beginning of 2004, he/she was told by

Rahoul Banerjea, former Digimare ID Systems Vice President of Finance, that the Company had



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eliminated all inventory reserves at the direction of R.anjit so the Company could meet earnings

expectations and that the Company could not write-down the overvalued inventory because that

would significantly reduce the Company's reported income and make the Company miss market

expectations . In fact, before the end of the Company's quarter ended June 30, 2004, Ranjit

ordered CW1 not to write down obsolete inventory because, according to Ranjit, due to the

elimination of the reserves (which Ranjit had also ordered), writing down obsolete inventor y

would result in the Company missing market expectations .

62 . The Company's failure to write down or write off obsolete, useless or destroye d

inventory directly contradicts GAAP and the Company's own publicly disclosed accounting

policy. Accounting Research Bulletin ("ARB") No . 43, Chapter 4, Statement 5 requires

companies to reduce the carrying value of their inventory and recognize a loss when the utility of

the inventory is no longer as great as its costs because of obsolescence, physical deterioration or

market conditions. Digimare's 2003 Form 10-K and each of its Form 10-Qs issued during the

Class Period,4 and signed by the Individual Defendants, falsely stated :

We value inventory at the lower of cost or market value (which lower amount isthe net realizable value) . We reduce the value of our inventory for estimatedobsolescence or unmarketable inventory equal to the difference between the costof inventory and the estimated market value based upon assumptions about futuredemand and market conditions . If actual market conditions are less favorable thanthose projected by management, additional inventory write-downs may berequired .

4 This identical language is included in Digimarc's Form 10-K for the year endedDecember 31, 2003, and the Company's Form 10-Qs for the quarters ended March 31, 2003, June30, 2003, September 30, 2003 and March 31, 2004 .


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63 . Despite these requirements, the Company's financial statements during the Clas s

Period failed to timely reflect the risk of slow moving or obsolete inventory through reserves o r

charges against income as required by GAAP and its own disclosed policies . Instead, the

Company's reported results included inventory which was grossly overstated .

64. During the Restatement process, according to CW3, the Company was required t o

bring in an outside consultant to perform a comprehensive and detailed investigation to unwind .

all of the improper expenses that were capitalized improperly and determine the true value of the

Company's inventory and fixed asset accounts during the Class Period . The Restatement

evidences that Digimarc's improper manipulation of its balance sheet allowed it to avoid materia l

amounts of expenses during the Class Period as set forth in the following table :

Accounting Period Amount of Expenses ImproperlyRecorded as Inventory or Fixed Asset s

Q2 2003 $15,00 0

03 2003 $81,000

04 2003 $357,000

U1 2004 $1,146,00 0

Total for $1,599,000Class Period

2) Improper Capitalization of Purported Internal SoftwareDevelopment Cost s

65 . As detailed further below, in the GAAP violations section entitled "Defendants '

Financial Statements During the Class Period Were '!Materially False and Misleading and Violated

GAAP," GAAP includes a specific provision deta :l :,A g when a company may capitalize the cost s

it incurs in developing internal software . See AICPA SOP No . 918-1, Accounting-for the Costs of

Computer Softvwware Developed or Obtained for Internal Use . Costs in the preliminary project


STOLL STOLL 33ERNE LOKTJNG & s[rLACH F It P .C .209 S .W . OAK STREET

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stage, where a company has not yet made a decision to pursue a software strategy, but rather is i n

the process of evaluating alternatives for the software and how to develop the software, must b e

expensed in the period they are incurred. In addition, once the internal use software is placed int o

service, all costs incurred to maintain the software must be expensed in the period they are

incurred, and the capitalized costs must begin to be amortized over the expected useful life of th e

software.

66. Digimarc's SEC filings falsely represented that the Company followed th e

requirements of SOP 98-1 . The Company' s 2002 and 2003 Form 10-Ks (which incorporate d

information from the Company's Form 10-Qs for 2002 and 2003) each state :

Internal use software development costs are accounted for in accordance withAICPA SOP No . 98.1, Accounting , for the Costs of Computer Software Developedor Obtainedfor Internal Use . Costs incurred in the pre liminary stage are expensedas incurred and costs incurred in the application development stage, which meetthe capitalization criteria, are capitalized and amortized on a straight - line basisover the estimated useful life of the asset, generally three to five years .

67. CW2 explained that, in early 2003, the Company eliminated internal contro l

processes intended to prevent the improper capitalization of payroll expenses . This was

corroborated by CW 1 . CW2 described a control process that he/she helped set up prior to th e

Class Period to confirm that an engineering employee who had entered time into the project tim e

and expense program for capitalization had truly spent the hours entered on tasks that qualified

for capitalization . The program would require the employee's direct supervisor or manager t o

confirm that the employee spent the time entered on a project, and that the work performed

qualified for capitalization . According to CW2, early in 2003, Val Ford, who reported directly t o

Ranjit, instructed hirn/her to re-program the time and expense software to eliminate the require d

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STOLL STOLE RGRNL LOK` NG & SHLACI ITRR P.C .209 S .W . OA : STREET

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supervisor or manager approval of time . CW2 further explained that Ford further instructed

him/her in early 2003 to re-program the time and expense tracking software so that administrative

assistants working in the finance department could enter time for the engineers, rather than having

the engineers enter their time directly . Most importantly, Ford instructed CW2 to give access to

secretaries and finance department managers so that finance personnel could access the time and

expense program by using a generic log-in and override and manipulate the amount of time and

expenses that were input for capitalization . In other words, during the Class Period Defendant s

changed the programming to enable finance personnel to manipulate the amount of software

payroll expense to be capitalized, and not coincidentally during this time the Company falsely

capitalized $1 .3 million of ordinary expenses as software development costs .

68 . When CW2 was first instructed to eliminate these accounting controls as set fort h

above, CW2 contacted CW1 who in turn approached Val Ford . Ford told CW1 that R.anjit had

ordered the controls removed . According to CW1, he/she then sent an email to Ranjit about the

elimination of controls in the capitalization of software payroll, and Ranjit responded that it was

what Ranjit wanted and that he expected CW 1 to take care of it . The obvious explanation for

these programming changes was to enable Digimarc's management to make changes in the time

and expense data to improperly boost the amount of capitalized payroll expenses and improperly .

increase Digimarc's reported earnings, which Digimarc has now admitted doing every quarter

during the Class Period .

69 . CW3 described conversations he/she had with other finance department personnel,

including Jennifer Waden, a Digimarc financial analyst with whom CW3 worked closely . Waden.

told CW3 that IndA a Paul, President of Digimarc's ID Systems business unit, instructe d


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employees during the Class Period to assign more payroll time to projects that were at a point

where the payroll costs could be capitalized, even if the employee's time was not spent working

on the projects that were appropriate for capitalization . In other words, Digimarc's senior

management was directing employees to capitalize payroll expenses that were not properly

capitalized under either GAAP or the Company's own accounting policy. Waden told CW3

during the Class Period that several employees approached her and complained about Paul's

direction to record their time to projects on which they were not working .

70. CW3 also had several discussions with implementation project managers who

were upset because payroll time was being assigned to the implementation of their projects

improperly, making their implementation budgets appear higher than was actually incurred .

Specifically, CW3 heard from the implementation project managers that payroll time was being

charged improperly to the implementation of new license programs in Florida and New Jersey

merely so that this time could be capitalized and not recognized as expenses, thereby improperly

and falsely boosting the Company's reported income .

71 . According to CW1, Susan Scacchi, a former ID Systems controller who reported

directly to Defendant Ranjit, told him/her that, at the close of the first quarter of 2003, Defendant

Ranjit ordered her to make last-minute journal entries that improperly increased the amount of

payroll that was capitalized . Scacchi objected strongly, and left the Company as a result of the

incident within weeks . Later, CW 1 learned from. Martin Day, then Digimarc's Controller, that

the Company had, made some of entries despite Scacchi's objections .

72 . Defendants have now admitted in the Restatement of their financial results that

Digimarc violated SOP 98-I and Digimarc's publicly-disclosed accounting policy, an d


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209S .W.OAK I RBE,T

PORTLAND, OREGON 97204TEL !503) 227-1600 FAX (503) 227-6840

improperly capitalized material amounts of ordinary expenses as software development costs .

Defendants, in fact, admitted that the Company capitalized as software development costs, certain

expenses that had nothing to do with the development of new software . This type of error

required the Company to falsely and repeatedly assign material amounts of costs that had nothing

to do with software development to a software development asset account, which is not

something that would occur accidentally . In its Restatement set forth in the 2004 Form 10-K and

its Form. 10-Q for the period ended September 30, 2004, the Company stated :

Capitalized software development costs . The Company produces software that isused internally, and as such has costs that qualify under the AICPA's SOP 98-1,Accounting for the Costs of Computer Software Developed or Obtained forInternal Use. The Company's policy requires expensing of activities related to thepreliminary stage of a software project (such as the conceptual formulation ofalternatives), allows capitalization of activities related to the applicationdevelopment stage of a software project (such as coding, installation, and testing),and requires expensing of activities related to the post- implen-mentation stage (suchas training , maintenance, and support) consistent with the guidance in SOP 98-1 ..Under this policy, the Company capitalizes costs in the application developmentstage of a software project . In connection with the restaterrent, the Companydetermined that certain costs had been erroneously capitalized because either aportion of such costs did not qualify for capitalization (e.g., costs related to the

preliminary or post-imple mentation stages) or the project itself did not qualify as

internal-use software (e.g., costs related to, a non-software project) .

73 . Moreover, despite their Class Period internal control certifications (J ; 86 and 124

below), Defendants further admitted that they did not provide adequate supervision or technical

accounting expertise within the accounting and finance department to implement their internal -

software capitalization policy, and that the Company- lacked sufficient controls for "determining

the nature and types of costs that should be capitalized in accordance with U .S . GAAP," and that

Company personnel lacked sufficient expertise in applying the Company's own softwar e

capitali :>ation policy .


STOLL STOL:.. 13FRNE LOKTING & SHLACNTER P .C,209 S .W . OAK STREET


74, Defendants also admitted that they lacked documentary support for capitalization

of'certain software development costs, they had an inadequate system for tracking costs that

purportedly qualified for capitalization, and had inadequate "detective controls" to determin e

whether costs that were being capitalized as software development costs qualified for

capitalization .

75 . In sum, Defendants set up an accounting and finance department with incentive to .

capitalize as many expenses as possible so the Company could meet analysts' earnin g

expectations . Senior management (in order to carry out Defendant Ranjit's expressed wishes)

directed the improper capitalization of payroll expenses, the Company provided inadequate

personnel to police whether the Company followed SOP 98-1, and the Defendants purposefully

eliminated the control process that was intended to prevent improper capitalization . The

Company further admitted it lacked any documentary support for the expenses that the Company

was capitalizing improperly and that it, quarter after quarter, falsely capitalized ordinary expenses

as software development costs that were not software development costs . Defendants either knew

or were deliberately reckless in falsely representing to the market that the Company complied

with AICPA SOP 98-1, as Defendants knew or recklessly disregarded that the Company lacked

the internal controls or expertise to follow GAAP with respect to capitalization of internal

software development costs, lacked the requisite evidentiary support for material amounts of

ordinary expenses that it was capitalizing as purported "internal software development" costs, and

created an environment where finance personnel had the ability and strong incentive to falsify,

and did in fact falsify, the amount of payroll costs that could be capitalized to boost reported

earnings .


STOLL STOIC . BERNE LOKTING & s LAciITP.R P .C.209 S,%V . OAK S FREE,'['

PORTLAND .OREGON 97204TEL . (503) 227-I600 f ,~ X (503) 227 6840

76. The Company has admitted that it improperly capitalized material amounts of

ordinary payroll expense in every quarter in the Class Period as follows :

ACCOUNTING PERIO D

Q 1 2003

Q2 2003

Q3 2003

Q4 2003

Q1 2004

IMPROPERLYCAPITALIZE D

PAYROLL

$149,000

$228,000

$331,000

$229,000

$403,00 0

Total for ClassPeriod

$1,340,00 0

B. DEFENDANTS FALSELY PORTRAYED DIGIMARC'S FUTUREPROFITABILITY AND GROWTH

77 . As set forth in detail below , throughout the Class Period, Defendants Davis an d

Ranjit provided detailed guidance to market analysts on what they purportedly expected regarding

Diginlare's financial performance . These statements were false and misleading when made as

Defendants were disregarding what Dig;nnarc's own internal budgets of revenues and expenses,

and senior management was making deceptive "adjustments" to these internal budgets in an effort

to convince the market during the Class Period that Digimare was growing its business an d

profits .

78. According to CW3, he/she spoke several times with Jennifer Waden, the financial

analyst in charge of creating Digirnarc's revenue and earnings budgets . According to CW3,

Waden was often upset because Waders would work hard to create realistic and supportable

forecasts of revenues and expenses and then Indra Paul, the former ID Systems President acting a t


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the behest of Davis and/or Ranjit, would change Waden's projections without any reasonabl e

basis and simply to improve the numbers for Wall Street . According to CW3, there were eve n

line items on Waden's internal budget spreadsheets for these unsupportable adjustments .

79 . CW3 explained, for example, that Indra Paul changed Jennifer Waden's interna l

forecasts by adding revenues where there was no basis to expect revenue growth beyond Waden' s

forecast, and Paul reduced Waden's forecasts for expenses without any reasonable basis .

According to CW3, Paul's direction to change the forecast came form Digimarc's corporat e

office in Tualatin . Also according to CW3, this was a constant source of frustration for Waden,

who complained to CW3 about senior management's improper manipulation of her forecasts on

several occasions during the Class Period. CW3 described Defendants' manipulation of Waden's

forecasts as "malicious" because management knew that the forecasts it provided to the market

were false and misleading .

80 . According to CWI, it was well known within the Company during the Class

Period, throughout the ID Systems business unit, but not publicly, that revenue based on drivers

license issuances was highly seasonal and there was always a big drop off in revenues in the

fourth quarter of the year . CW1 was involved in several conversations with Defendant Ranjit

before and during that time where Ranjit and other ID Systems employees made it clear that

revenues would usually drop off late in the year because drivers license issuances are always

lower toward the end of the year . According to CW 1, it was well known within the Company

that Digimarc's publicly-disclosed projections of revenue and earnings growth were unrealistic,

especially for the fourth quarter 2003 accounting period .


STOLL, STOLL BERNF L.OKTFN( & Sl ILACHTER P.C .209 S .W- OAK STREET


81 . The discrepancy between Digimarc's Class Period statements of future expected

revenue and earnings and the Company's actual, restated results is highly probative of deliberate

falsity rather than innocent optimism . For example, on October 21, 2003, Defendants caused

Digimarc to issue a press release stating that Digimarc expected revenues of $24 million to $25

million for the fourth quarter of 2003, which represented a projected 8-12% growth in revenues

over the third quarter of 2003 . Defendant Ranjit repeated. these projections in a conference call

with analysts on October 21, 2003 . After the Restatement, Digimarc ultimately reported revenue s

of $19 million and a loss of $613,000 .

82. Likewise, on February 24, 2004, Defendants caused Digimarc to issue a press

release setting forth projections of revea:wes and earnings for the year ended December 31, 2004 .

This press release stated that Defendants expected Digimarc to generate revenues of $94 million

to $97 million and earnings of $6 .4 million to $7 .5 million or $0 .30 to $0.35 per share for the year

ended December 31, 2004, Ultimately, after the Restatement Digimarc reported revenues of $93

million and, instead of 86.4-7.5 million in profit, a huge loss of over $9 million for 2004 .

DEFENDANTS' FALSE AND MISLEADINGSTATEMENTS DURING THE CLASS PERIO D

A. FALSE STATEMENTS REGARDING DIGIMARC'SFIRST QUARTER 2003 FINANCIAL RESULTS ANDEXPECTED RESULTS FOR FUTURE PERIOD S

83 . The Class Period begins on April 22, 2003 . On that date, Digimarc issued a press

release entitled "Digimarc Reports First Profitable Quarter As A Public Company," containing its

financial results for the first quarter of 2003, the period ended March 31, 2003 ("IQ 03 ") . It

announced total revenues of $21 .7 million and net in(-.ome of $29,000 and purportedly marked th e

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STOLI . STOLC 13ERNG I OKTft G & SIILAC11TBR P.C.

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Company's first profitable quarter as a public company, "culminating five -consecutive quarters of

continuous improvement in financial and operating performance," according to Defendants . It

also provided, in relevant part :

Total revenues for the first quarter of 2003 were $21 .7 million, up $3 .2

million or 18% frol-n the $18 .5 million reported in the comparable period of 2002 .Basic and diluted earnings per share for the first quarter of 2003 were $0 .00 based

on 17 .66 million weighted average shares outstanding for the quarter (basic) and

18 .35 million weighted average shares outstanding for the quarter (diluted) . Thiscompares with basic and diluted net loss per share of $0 .24 based on 17 .11 millionweighted average shares for the comparable period of 2002 .

84. Defendant Ranjit was quoted in the April 22, 2003 release as stating :

Our financial performance for the quarter was solid with a 4% sequentialgrowth in total revenues from last quarter and modest profits . . . . Both revenues andprofits were within our guidance for the quarter, and our profitability this quartermarks a major milestone for Digimarc as a public company . In addition, grossprofit at 45% of total revenues exceeded our expectations . The improvement ingross profit was primarily driven by a favorable product mix and our continuingefforts to improve operating efficiencies .

85 . Defendant Davis offered these comments in the April 22, 2003 release :

Our success in the quarter was primarily the result of continuingperformance improvements in our ID Systems business, where the team deliveredsequential growth in revenues, improved margins, and lower costs . . . . ID Systems'exceptional performance not only drove financial results but also the adoption ofdigital watermarking technology .

86. On May 15, 2003, Digimarc filed with the SEC a Form 10-Q for IQ 03, the period

ended March 31, 2003, reiterating the infonnation released to the market in the April 22, 2003 -

press release . The first quarter Form 10-Q was signed by Defendant Ranjit, and was certified by

Defendants Davis and Ranjit pursuant to §§ 302 and 906 of Sarbanes-Oxley . The certifications

submitted pursuant to § 906 of Sarbanes-Oxley, signed by Defendants Davis and Ranjit, indicated

in pertinent part that "(1) [t]he Report fully complies with the requirements of Section 13(a) or



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15(d), as applicable, of the Securities Exchange Act of 1934 ; and (2) [tjhe information contained

in the Report fairly presents, in all material respects, the financial condition and results of

operations of the Company at the dates and for the period indicated," and Section 302, also signed

by Defendants Davis and Ranjit, purported to certify the veracity of the Company's financial

statements and the adequacy of the Company's internal controls, as set forth in ¶( 124 below .

87 . As detailed in the section above entitled "Facts Undermining Defendants' Clas s

Period Representations," Defendants' statements regarding Digimarc's financial performance in

1Q 03 were false and misleading when made . Digimarc was not profitable in that quarter, nor

was the Company continuing its performance improvements . Digimarc manufactured the

reported profit by improperly failing to expense $179,000 of ordinary payroll and tax expenses

the Company had incurred. Contrary to Defendants' statements, Digimarc did not experience a

modest profit in IQ 03, but suffered a loss of $150,000 .

88. Digimarc's April 22, 2003 press release also provided investors with specifi c

guidance as to the Company's 2003 outlook through the following relevant statements :

Digimarc estimates that second quarter 2003 total revenues will be in therange of $21 .2 million to $22 .0 million . . . .

Digimare expects gross profit in the second quarter of 2003 to be in therange of 45 to 47 percent . . . .

Digimarc expects combined operating expenses for research, development °-and engineering and selling, general and administrative of approximately $9 . 1

million to $9.7 million in the second quarter of 2003 . . . .

Digimarc expects non-cash charges related to the amortization of deferredstock compensation to be approximately $450,000 in the second quarter . Thesecharges relate to options granted to employees in 1999, prior to the company'sinitial public offering. The company will record the last of these charges in thefourth quarter of 2003 .


STOLL STOLL 13CRNr_ LOKT!NG & SHLACIT-ER P .C.209 S .W . OAK STREET

PORTLAND, OREGON 97204TEL ( 503)227-)600 FAX(503)227-6340

Digirnare expects to record a provision for income taxes of approximately$50,000 during the second quarter of 2003 that relates to taxes payable in foreignlocations. Income taxes for domestic operations are expected to be zero during thesame period due to net operating loss carry forward benefits the company has fromprior periods .

Digimarc expects other income, consisting mainly of interest income, to beapproximately $105,000 in the second quarter of 2003, assuming no materialchange in average cash balances or interest rates from the first quarter .

Digimarc estimates diluted earnings per share to be in the range of $0 .00 to

$0 .02 for the second quarter of 2003 . For the full year 2003, we remaincomfortable with the First Call Consensus of $0.21 diluted earnings per share .

89 . Defendant Ranjit repeated these projections in Digirnarc's earnings conference cal l

with analysts on April 22, 2003 .

90. Defendants' April 22, 2003 statements regarding anticipated future results wer e

false and misleading as Defendants failed to disclose its 1Q 03 results were based on improper

and false accounting for expenses and Defendants did not disclose that they had manipulated the

internal budgets prepared by Digimarc's forecasting personnel, adding revenues and subtracting

expenses from these internal budgets without any reasonable justification (as described above in

the section entitled "Facts Undermining Defendants' Class Period Representations") .

B. FALSE STATEMENTS REGARDING DIGIMARC'SSECOND QUARTER 2003 FINANCIAL RESULTS ANDEXPECTED RESULTS FOR FUTURE PERIOD S

91 . On July 22, 2003, Digimarc issued a press release entitled "Digimarc Reports -

Second Quarter Results, Marking Sixth Consecutive Quarter of Improved Financia l

Performance," for its second quarter 2003, the period ended June 30, 2003 ("2Q 03") . The

release stated, in relevant part :

Digimarc Corporation today announced total revenues of $22 .5 million and netincome of $287,000 for the quarter ended June 30, 2003 .


STOLL STOLL BYRNE LOKT[\(, & SHLACE ITER P .C.209 S .W. OAKS' T RBE I '

PORTLANII, ORLGOA19120 4

TEL . (503) 227-1600 FAX (503) 227-6840

This marked the company's second consecutive profitable quarter as apublic company, and its sixth consecutive quarter of improved financialperformance .

Total revenues for the second quarter of 2003 were $22 .5 million, up $1 .7

million or 8% from the $20 .8 million reported in the comparable period of 2002 .Basic and diluted net income per share for the second quarter of 2003 were $0 .02based on 17.79 million weighted average shares outstanding for the quarter (basic)and 18.54 million weighted average shares outstanding for the quarter (diluted) .This compares with basic and diluted net loss per share of ($0 .20) based on 17 .29million weighted average shares for the comparable period of 2002 .

Total revenues for the first six months of 2003 were $44 .3 million, up $5 .0

million or 13% from the $39 .3 million reported in the comparable period of 2002 .Basic and diluted net income per share for the first six months of 2003 was $0.02compared to basic and diluted net loss per share of ($0 .44) reported in th e

comparable period of 2002.

"We are pleased with our second quarter results, which saw revenues growsequentially and exceeded our guidance," said E .K. Ranjit, CFO of Diginlare ."We reported a second consecutive quarter of profitability that exceeded First Callearnings per share consensus by 1 cent for the quarter . Furthermore, we sawcontinued improvement in key financial performance indicators and generatedpositive cash flow from operations . "

"Our Q2 financial performance reflects the steady progress that our IDSystems' business has made over the past 18 months as we establish Digimarc as aleading force in the global secure personal identification marketplace . During the

quarter, we began to demonstrate the synergy between our principle areas ofbusiness, as Nebraska, New Jersey, Michigan-and Vermont announced adoption ofdigital watermarking security features in their drivers licenses . We expect manymore states to do likewise in the near future . This combination of a well-managedbusiness and leading edge security solutions enables us to provide issuingauthorities with highly cost effective means to establish secure persona lidentification," said Bruce Davis, Digimarc chairman and CEO. --

Davis continued, noting that "secure personal identification solutions is asubstantial growth opportunity for digital watermarking as it adds momentum tothe early successes we've seen in counterfeit deterrence and copyright protectionapplications . There was a big success story in the quarter in these areas whenCorhis, one of our long-standing customers for Digimarc 'ImageBridge'watermarking and a leading supplier of creative, news, historical, celebrity and artimagery, was widely quoted rega•ding the .~xtraordinary success they have enjoye d


STOLL STOLL BERNL LOKTING & SHLACIHTLR P.C .209 S .W . OAK STREET


in using our watermarking solutions for identifying and monetizing unlicenseduses of their imagery . "

Finally, Davis, commenting on Digimarc's continuing improvements inalignment of the company's resources to foster profitable growth, remarked that"to capitalize on these successes and continue to provide strong custome rsatisfaction and shareholder value, we have organized the company into a portfolioof peer-level operating units under a corporate umbrella, with two units :Watermarking Solutions and ID Systems, overseen by a small corporate staff . The

new structure will facilitate effective management of the continuing growth andexpansion of our business ."

92 . The July 22, 2003 press release provided the following outlook as part of its

"Business Outlook" :

Digimarc estimates that third quarter 2.003 total revenues will be in the

range of $23 .0 million to $24 .0 million . . . .

Digimarc expects the percentage of gross profit to total revenues in thethird quarter of 2003 to be in the range of 43 to 46 percent. . . .

Digimarc expects combined operating expenses for research, developmentand engineering and selling, general and administrative of approximately $9 .5

million to $10 .5 million in the third quarter of 2003 . . . .

Digimarc expects non-cash charges related to the amortization of deferredstock compensation to be approximately $300,000 in the third quarter . Thesecharges relate to options granted to employees in 1999, prior to the company'sinitial public offering. The company will record the last of these charges in thefourth quarter of 2003 .

Digimare expects to record a provision . for income taxes of approximately$50,000 during the third quarter of 2003 that relates to taxes payable in foreign

locations . Income taxes for domestic operations are expected to be zero during thesame period due to net operating loss carry forward benefits the company has fromprior periods .

Digimarc expects other income, consisting mainly of interest income, to beapproximately $150,000 in the third quarter of 2003, assuming no material changein average cash balances or interest rates from the first quarter .


STOLE STQLI_ BrRNE LOKT[NG & SI ILACHTER P .C.209 S .W . OAK sTPErT

PORTLAND, OREGON 97204TEL(503)227-1600 FAX(503)227-6840

Digimarc estimates diluted earnings per share to be in the range of $0 .05 to

$0.07 for the third quarter of 2003 . For the full year 2003, the company iscomfortable with the First Call Consensus of $0 .19 diluted earnings per share .

93 . Defendant Ranjit repeated these projections in Digimarc's earnings conference cal l

with analysts on July 22, 2003 .

94. Defendants' July. 22, 2003 statements regarding anticipated future results were

false and misleading when made as Defendants failed to disclose that Digimare's I Q and 2Q 03

results were based on improper and false accounting for expenses and Defendants did not disclose

that they had manipulated the internal budgets prepared by Digimarc's forecasting personnel ,

adding revenues and subtracting expenses from these internal budgets without any reasonabl e

basis (as described above in the section entitled "Facts Undermining Defendants' Class Perio d

Representations") .

95 . On August 14, 2003, Digimarc fi led with the SEC Form 10-Q for 2Q 03, the

period ended June 30, 2003, reiterating the information released to the market in the July 22, 200 3

press release . The 2Q 03 Form I0-Q was signed by Defendant Ranjit, and was certified by

Defendants Davis and Ranjit pursuant to §§ 302 and 906 of Sarbanes -Oxley .

96. Defendants' statements regarding Digimarc's financial performance in 2Q 03 wer e

false and misleading when made because, as detailed in Jill 28-76 above, Digimarc materiall y

overstated its reported earnings by S 191,000 and failed to expense $228,000 of ordinary payroll

the Company had incurred . Indeed, approximately two-thirds of the $287,000 of the Company' s

reported income for this period was false .

Page 4~, - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LA W

STOLL STOLL 13LRNE 1 OKTING & SE[LACHTUR P .C.209 S.W . OAK STREEL'


C. FALSE STATEMENTS REGARDING DIGIMARC'STHIRD QUARTER 2003 FINANCIAL RESULTS ANDEXPECTED RESULTS FOR FUTURE PERIOD S

97 . On October 21, 2003, Digimarc issued a press release entitled, "Digimarc Report s

Third Consecutive Quarter of Improved Profitability," that contained its financial results for the

third quarter 2003, the period ended September 30, 2003 ("3Q 03") . The release announced total

revenues of $22 .3 million and net income of $1 .3 million, marking the Company's third

consecutive profitable quarter, and its seventh consecutive quarter of improved financia l

performance . The release also provided the following relevant parts :

Total revenues for the third quarter of 2003 were $22 .3 million, down $4 .2

million or 16% from the $26 .5 million reported in the comparable period of 2002,which included revenues from an unusually large international sale that was fullydelivered during that period. Basic and diluted net income per share for the third

quarter of 2003 were $0.07 based on 18 .75 million basic and 19 .73 million diluted

weighted average shares. This compares with a net loss per share of 50 .05 based

on 17 .46 million weighted average basic and diluted shares for the comparableperiod of 2002 .

Total revenues for the first nine months of 2003 were $66 .6 million, up

$0.7 million or 1% from the $65 .8 million reported in the comparable period of

2002. Basic and diluted net income per share for the first nine months of 2003were $0 .09 and $0.08, respectively, compared to basic and diluted net loss per

share of $0 .49 reported in the comparable period of 2002 .

98 . The October 21, 2003 release also contained Company guidance for the fourth

quarter and year end 2003 . It estimated that fourth quarter total revenues in the range of $24 .0

million to $25 .0 million, gross margins to be in the range of 44 to 46 percent, combined operating

expenses for research, development and engineering and selling, general and administrative of

approximately $9.5 million to $10 .5 million, other income, consisting mainly of interest income,

to be approximately $170,000, diluted earnings per share to be in the range of $0 .07 to $0 .10. For


STOLL STOLL BrRNE LOKTINc & SHLACHTER P .C .

209 S .W. OAK STREE TPORTLAND, OREGON 9720 4

TEL . (503 ; 227-1600 FAX (503) 227-6840

the full year 2003, the Company expected diluted earnings per share to be in the range of $0 .15 to

$0.18 .

99. Defendant Ranjit repeated these projections in Diginnarc's earnings conference cal l

with analysts on October 21, 2003 .

100. Defendants' October 21, 2003 statements regarding anticipated future results wer e

false and misleading when made, as Defendants failed to disclose that Digimare's IQ, 2Q and 3 Q

03 financial results were based on improper and false accounting for expenses and Defendants did

not disclose that they had manipulated the internal forecasts prepared by Digimarc's forecastin g

personnel, adding revenues and subtracting expenses from these internal forecasts without an y

reasonable basis (see "[1177-82) . Defendants further knew that their forecast of material revenu e

growth for the fourth quarter over the third quarter was false and misleading when made becaus e

they knew that drivers license issuances are seasonal and a drop off in the fourth quarter was

inevitable .

101 . On November 14, 2003, Digimare iced with the SEC Form 10-Q for 3Q 03, the

period .ended September 30, 2003, containing the information released to the market in th e

October 21, 2003 press release . The 3Q 03 Form 10-Q was signed by Defendant Ranj it, and was

certified by Defendants Davis and Ranjit pursuant to §§ 302 and 906 of Sarbanes-Oxley

102 . Defendants' statements regarding Digimarc's financial performance in 3Q 03 were

false and misleading when made because Digimarc materially overstated its reported earnings b y

$442,000 . :n this quarter . Digimarc failed to expense $411,000 of ordinary payroll and other

expenses the Company had incurred . Indeed, approximately one-third of the $1,284,000 of th e

Company's reported income for this period was false .

Page 4'/' ;- SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LAW

STOLL STOL L B RNE,1.OKTING & SHLACHTER P .C .209 S. W . OAK STREET

PORTLAND, OREGON 9720 4TEL . (503 ) 227-1600 FAX (503 ) 227-6840

D. DEFENDANTS' FALSE STATEMENTS REGARDINGDIGIMARC'S 2003 YEAR-END FINANCIAL RESULTSAND EXPECTED RESULTS FOR FUTURE PERIOD S

103 . On January 20, 2004, the Company issued a press release entitled , "Digimar c

Reports Preliminary Fourth Quarter and Year-End 2003 Financial Results ; and Provides Business

Update and Preliminary 2004 Financial Guidance," for the fourth quarter 2003, the period ended

December 3 .1, 2003 ("4Q 03") and year end 2003 ("FY 03") . The release announced that the

Company expected to report total revenues of approximately $19 .0 million and net income for th e

fourth quarter of approximately $0.03 diluted earnings per share . The Company had previously

anticipated total revenues in the range of $24 to $25 million and diluted earnings per share in the

range of 50 .07 to 50.10 for the quarter . "As a result of lower than anticipated revenues in the

quarter, the [Company now expects to report, for the fiscal year ended Dec . 31, 2003, total

revenues of approximately $85 .0 million and diluted earnings per share of approximately $0 .1 l . "

104. The January 20, 2004 press release also contained statements by Defendants Davi s

and Ranj it,

"The fourth quarter 2003 shortfall in revenues and profits was due to a

number of factors," said E .K. Ranjit, CFO of Digiznarc . "There were three main

factors . First, an order for a foreign voter identification program that was

originally forecasted to be awarded in the third quarter and to be partially shipped

in the fourth quarter did not happen . In addition, certain billable activities related

to the New Jersey drivers license system were delayed due to delays in the

implementation of the system beyond our control . The third significant factor

contributing to the revenue shortfall was unexpectedly low domestic driver licenseissuance volumes due to seasonality and wind-down of issuance in some former

accounts ."

According to Bruce Davis, chairman and CEO of Digimarc, "While theshortfall in Q4 revenues was disappointing , we anticipate a quick return togrowth and continuing improvements in financial perfor^fmiance . Regarding theprimary contributors to lower than expected revenues, the voter identificatio n


STOLL STOLL BGRNE LOKT1NG & SHLACHTER P .C.209 S.W OAK STREET

PORTLAND, OREGON 9720 4TE ; . . (503) 227- 1 600 FAX (503) Z27-6840

opportunity was for a legacy film-based system with relatively low margins andlittle strategic value . The delayed New Jersey shipments are being made in Ql andthe system there is now operational . The lower issuance volumes in Q4 resultedfrom seasonality, coupled with the effects of wind-down of issuances in Marylandand Oklahoma. The combination of the wind-down of these contracts andseasonality has created a trough in Q4 of 2003 and Q1 of 2004 that will beremedied as the new Florida drivers license system and other implementationactivities begin to generate revenues . The Florida contract alone will more thancompensate for the lost volume from these states when it becomes operational laterthis year . "

Supporting Davis's view that the downturn will be short-lived, thecompany announced today that it has been awarded a major contract win inMexico. The federal agency in Mexico responsible for issuing photo ID cards t oeligible voters for local and federal elections has awarded to Digimarc a four-yearcontract to supply voter identification cards that is anticipated to generate morethan $19 million in revenues . Implementation of the program has already begunand the first cards are expected to be produced prior to mid-year 2004 .

Davis went on to say that "we are seeing a number of promisingdevelopments in digital watermarking, including continuing rapid adoption ofdigital watermarking in drivers license programs by nine states who account forapproximately 20% of all drivers licenses issued annually in the United States .Massachusetts, Alabama and Florida are the latest states to adopt digitalwatermarking. Coincidentally, digital watermarking appears to be gaining favoramong producers and distributors of movies, music and television programming asa means of persistent content identification supporting a variety of importantbusiness processes ."

105 . The January 20, 2004 release also provided the following guidance to investors :

Company management estimates that first quarter 2004 total revenues willbe in the range of $20 .0 million to $21 .0 million, with diluted earnings per share in

the range of $0 .02 to $0.04. For the full year 2004, management expects dilutedearnings per share to be in the range of $0 .30 to $0.35, based on estimated totalrevenues for full year 2004 in the range of $92 .0 million to $95 .0 million .

The company further anticipates robust growth in 2005, as several recentcontract wins reach full deployment, including the Mexican voter identificationprogram and Florida driver license system .

106. The January 20, 2004 statements by Defendants partially undermined the fals e

perception Defendants had created that Digimarc was a successful company with growing profits .

Page 49 - SECOND AMENDED CLASS ACTION COMPLAINT . FOR VIOLATION OF


STOLL S COI L BERNE LOKTING & SI1LACHTER Y .C .

209 S .W. OAK STREET


However, the statements did not reveal the full extent of Defendants' fraud or fully correct the

market's misperception of Digimarc as a profitable company . Defendants' January 20, 2004

statements were false and misleading when made because Defendants did not disclose that they

had engaged in false accounting practices, which materially increased Digiinare's reported

earnings for the first three quarters of 2003 . Nor did Defendants disclose that they continued to

engage in additional fraudulent accounting with respect to 4Q 03 . Defendants' statements that the

revenue decline in 4Q 03 was unexpected was false and misleading when made, as Defendants

knew that drivers license issuances normally drop off substantially in the fourth quarter. Further,

Davis' statement that the Company expected to make a quick return to growth and continuing

improvements in financial performance was false and misleading when made as the Company

was experiencing significant losses and was becoming increasingly dependent on false accounting

practices to boost reported earnings (as detailed above) .

1 .07. Moreover, Defendants' January 20, 2004 statements regarding anticipated 200 4

results were false and misleading when made, as Defendants failed to disclose that Digimarc's

2003 financial results were based upon improper and false accounting for expenses . Defendants

also failed to disclose that they had manipulated the internal forecasts prepared by Digimarc's

forecasting personnel, adding revenues and subtracting expenses from these internal forecasts

without any reasonable basis .

108 . In response to the January 20, 2004 announcements and statements partially

revealing the company's true financial condition, on January 21, 2004, Digimarc stock fell from

$14.95 per share to $12 .78 per share on unusually high trading volume of 558,200 shares . Had

Defendants fully revealed Digimarc's true financial condition, as well as Defendants' serious



s-T-oi. L s'roi,i, BFtznr-. L_OKTING & sULMcr rrER P .C.209 S.W . OAK srREET

PORTLAND . OREGON 97204TEL . (503) 227-1600 FAX(503)227-6940

financial control problems and false manipulation of internal revenue and earnings forecasts, th e

price of Digimarc's stock would have declined even further than it did and remained depresse d

throughout the remainder of the Class Period .

109 . On February 10, 2004, Digimarc announced in a press release that Defendan t

Ranjit, the Company's Chief Financial Officer since August 1999, intended to "retire" later thi s

year. The release stated, "Ranjit expects to remain in his .current role with the company until his .

successor has been selected and retained by the company, in order to ensure a smooth transition .

Digimare is engaged in a search for candidates for the position and has retained The Brentwood

Group, Ltd., an executive search firm to assist in the process ." The announcement of Defendant

Ranj it's departure just prior to the disclosure of Digimarc's improper accounting and lack of

financial controls during his tenure as CFO, is highly suspicious .

110. On February 24, 2004, the Company issued a press release with its 4Q 03 and F Y

03 results as follows :

Digimarc's total revenue for the fiscal year ended December 31, 2003 was

$85 .6 million, or 1% lower as compared to $86 .6 million for the prior fiscal year .The company reported net income for the year of $1 .5 million, or diluted earnings

per share of $0 .08, as compared to a net loss of $8 .7 million, or diluted net loss per

share of $0 .50 in 2002 .

Total revenue for the fourth quarter of 2003 was $19 .1 million, or 8%

lower as compared to $20 .8 million for the fourth quarter of 2002. For the fourthquarter, the company reported net loss of $70,000, or net loss per basic and dilutedshare of $0 .00 based on 20 .06 million weighted average shares outstanding for the

quarter . This compares with a net loss of $225,000 or net loss per basic anddiluted share of $0 .01 based on 17 .57 million weighted average shares for thecomparable period of 2002 .

Total operating expenses for 2003 were $38 .2 million, or 14% lower ascompared to $44 .4 million for 2002 . Total operating expenses for the fourthquarter were $8 .9 million as compared to $9 3 million for the fourth quarter of


STOLL S TOLL BERNE, 1,OKT1N(-J & SHLACHTER P .C.209 S.W . OAK STREE T

PORTI AND, OREC)N 9720 4TEL (503) 227-i 600 PAX (503) 227,6940

2002 . The decreased expenses for fiscal year 2003 over the comparable period forthe prior year were primarily a result of continuing consolidation and streamliningof operations .

For the fourth quarter and full year 2003, the company reported earningswhich were lower than the revised guidance released by the company on January20, 2004 due to the discovery, during the company's closing process and audit, ofinventory and accounts payable posting errors related to the company's newaccounting system . The errors, which have been identified and corrected, ledmanagement to overestimate anticipated earnings per share for the fourth quarterand full year 2003 in the company's previously released revised guidance . Prior

periods were not affected .

111 . The February 24, 2004 release also contained "Updated First Quarter and Ful l

Year 2004 Guidance ." It provided, in relevant part, the following guidance for first quarter 200 4

and fiscal year 2004 :

We are increasing our revenue guidance range for first quarter 2004 to $23million to $24 million from our previous guidance range of $20 million to $21

million . . . . We are increasing our guidance for full year 2004 revenues to $94

million to $97 million from our previous guidance range of $92 million to $95

million . . .

We expect gross margins in the first quarter of 2004 to be in the range of38 to 43 percent . . . .

We expect combined operating expenses for research, development andengineering and selling, general and administrative of approximately $9 .0 million

to $9.5 million in the first quarter of 2004 . . . .

We expect other income, consisting mainly of interest income, to beapproximately $175,000 in the first quarter of 2004, assuming no material changein average cash balances or interest rates from the fourth quarter ending cashbalance .

Based on the above assumptions, we ,,,;timate diluted earnings per share to

be in the range of $0 .02 to $0 .04 for the first quarter of 2004 based on 20 .90

million weighted average shares . For the full year 2004, we expect diluted

earnings per share to be in the range of $0 .30 to $0 .35 based on 21 .25 million

weighted average shares .


STOLL STOLL BERNE LOKT!NC & SHLACHTER P .C .209 S .W . OAK STREE T


TEL . (503) 227-1600 FAX (503) 227-6840

112. Defendant Ranjit repeated these projections in Digimarc's earnings conference cal l

with analysts on February 24, 2004 .

113, On March 5, 2004, the Company issued a press release entitled , "Digimarc

Provides Additional Financial Information on 2004 Guidance" :

The guidance being supplemented was provided by the company in itsFebruary 24, 2004 earnings release and conference call discussing 2003 results .

The company, in its February 24, 2004 earnings release and conferencecall, gave guidance as to its full year 2004 revenues of between $94 and $97million, with an increase in full year 2004 diluted net earnings per share tobetween $0 .30-$0.35 based on 21 .25 million weighted average shares .

In December 2001, Digimarc acquired essentially all the assets of theLarge Government Programs business of Polaroid Corporation ("LGP") . Theseassets formed the basis of Digimarc ID Systems ("ID Systems") . ID Systemsaccounted for 89% of 2003 revenues and is expected to represent approximately89% of 2004 revenues .

The LGP strategic acquisition has contributed significantly to propagationof Digimarc's proprietary digital watermarking technology as a security feature ofsecure personal identification documents as well as to the company's significantlyimproved financial performance during 2003 . ID Systems is expected. to continueto comprise a significant majority of the company's revenues in 2004 . Due to thenature of the ID Systems business and revenue recognition policies, the companyincurs significant non-cash charges for depreciation and amortization that it doesnot incur in association with revenues generated in the Watermarking Solutionsarea of the business .

Given the relative contribution of ID Systems revenues to total revenuesand the inherent differences in financial characteristics of Digimarc's two primar ysources of revenues, the company believes that providing additional detail ---regarding sources of revenues, gross margins, and certain non-cash expenses wil l

help investors better understand Digimarc's underlying financial performance andability to generate cash flow from operations . Therefore, the company has decidedto include in its routine shareholder updates, a breakdown of revenues and grossmargins for ID Systems vs . Watermarking Solutions, and add calculation ofEBITDA to its reports of operating and net income .

In reporting EBITDA, the company will specifically identify theamortization of intangibles from the LGP acquisition . These intangibles represent


STOLL STOLL 13ERNE LOKTING & S1[LACHTER P .C .209 S .W .OAK STREE T


the value of long term customer relationships that were among the assets acquired .

They amounted to $23 .6 million at December 31, 2003, and are generallyamortized over 12 years from the date of acquisition . The useful life of theunderlying contracts is adjusted up or down from time to time, depending onchanges in the specific customer relationships due to extensions, renewals, andterminations of the associated contracts .

The additional financial detail referred to above is shown in the followingtable (in thousands, except per share data) :

2003 2004E 2004E(low) (high)

Total Revenues :

Digital $ 9,305 $ 10,000 $ 11,0A0

Watermarkin g

ID Systems $76,313 $ 84 ,000 $ 86,00 0

Total $ 85,618 $ 94,000 $ 97,000

% Rro3eh 10% 13%

Percent of Revenue :

DijZ i tal 11% 11% 1 1Watermarking

1D Systems 89% 89% 89 %

Gross Margin

Digital 60% 60% 62%

Watermarking

1D Systems 44% 42% 44%

Total 46% 44% 46°-/0

Net Income $ 1,530 $ 6,400 $ 7,500

Ir0wLI 318% 390%

EPS $ 0 .08 $ 0 .30 $ 0 .35

Page 54 - SECOND) AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LAW

STOLL STOL'., 33ERNE LOKT1N ; & SDLACHTER P .C.209 S. W . OAK STREET

PORTLAND, OREGON 97204TEL . (503) 227,1600 FAX (5 03) 227-6840

00EBITDA 513,107 $17,6

gro th 34%

The reconciliation of GAAP and Non-GAAP Financial Measures for 2003and 2004 Anticipated Financial Results is included in the following table (inthousands) :

2003 2004E 2004 E(low) (high )

Net income $ 1,530 $6,400 $ 7,500

% growth 318% 390%

Provision for taxes 203 200 300

Interest income, net 673 (700) E001

Amortization (contained in 4,559 2 ,400 224400O Ex

Depreciation (OpEx portion ), 2,076 1,800 2,00 0

Depreciation (COGS portion) 5,412 7,500 7,900

EBITDA $13,10 7 $ 1.7,600 $19,40 (

% growth 34% 48 %

114. Defendants' February 24, 2004 and. March 5, 2004 statements regarding

$ 19,400

48%

anticipated future results were false and misleading when made as Defendants failed to disclos e

that Digimarc's 2003 financial results were based on improper and false accounting for expenses,-

and Defendants failed to disclose that they had manipulated the internal forecasts prepared b y

Digimarc's forecasting personnel, adding revenues and subtracting expenses from these interna l

forecasts wi!hout any reasonable basis . See Jill 77-82 above .

115 . On March 15, 2004, Digimarc filed with the SEC its Form 10-K for the year ended

December 31, 2003, reiterating the information released to the market in the February 24, 2004

Page 55 - SECOND AMENDED CLASS ACTION COMPLAINT FOR.VIOLATION OFTHE FEDERAL SECURITIES LAW

STOLL STOLL BERNE LOKTI,!G & SHLACHTER P.C.209 S .W . OAK STREET'

PORTLAND, OREGON 972041 EL, (503) 227-1600 FAX X503) 227-6840

press release. The 2003 Form 10-K was signed by Defendants Davis and Ranjit, and was als o

certified by Defendants Davis and Ranjit pursuant to § 302 and 906 of Sarbanes-Oxley .

-116. Defendants' statements regarding Digimarc's financial performance for the year

ended December 31, 2003 were false and misleading when made because Digimarc materially

overstated its repor .ed earnings by $1,355,000 by improperly capitalizing and failing to expense

ordinary payroll and other expenses the Company had incurred. Indeed, approximately 90% of

the Company's 2003 reported income was false, as discussed above .

E. FALSE STATEMENTS REGARDING DIGIMARC'SFIRST QUARTER 2004 FINANCIAL RESULTS ANDEXPECTED RESULTS FOR FUTURE PERIOD S

117. On April 29, 2004 , Digimarc issued a press release entitled, "Digimar c

Corporation Announces First Quarter 2004 R .esults," containing its financial results for the first

quarter ► f 2004, the period ended March 31, 2004 (" 110 04"), which announced total revenue for

the first: quarter wao $23 .5 million, or 8% higher as compared to $21 .7 million reported in the

comparable period of 2003 . The release also stated :

The'company reported net income of $525,000 or net income per basic and diluted

share of $0 .03 based on 20 .21 million (basic) and 20 .62 million (diluted) weighted

average shares outstanding for the quarter, respectively . This compares with net

income per basic and diluted share of $0 .00 for the comparable period of 2003 .

Total operating expenses were $9 .4 million as compared to $9 .8 million for the

first quarter of 2003 . Earnings before Interest, Taxes, Depreciation and

Amortization ("EBITDA") were $3 .2 million for the first quarter of 2004

compared to $2.7 million in the first quarter of 2003 . EBITDA is calculated by

adjusting net income for the effects of interest, taxes, depreciation, and

amortization .

18 . Defendant Davis was quoted in the April 29, 2004 release as saying :

Our ;first quarter financial performance was solid, as we delivered revenuesand earnings n line with our guidance . . . . While doing this, we also mad e


S1'OL .C.. St'OLE .BORNE LOKTING & SHLAC1ITER P .C .209 S .W. OAK STRU T

'ORTLAND, OREGON 9720 4TE1, . (507) 227-1600 FAX (503 ! 227-6840

considerable progress in'several large new program deployments, which we expectwill have a significant positive impact on our revenues and earnings in the secondhalf of the year and beyond .

119 . The April 29, 2004 release also provided the following guidance for the secon d

quarter and fiscal year 2004 :

Company management estimates for the second quarter of 2004 are :

1 . Total revenues in the range of $21 .8 million to $22 .8 million ;2. Gross margins in the range of 44 to 46 percent ;3 . Combined operating expenses for research, development and engineeringand selling, general and administrative of approximately $9 .7 million to $10 .3

million ;4. Other income, consisting mainly of interest income, of approximately$175,000, assuming no material change in average cash balances or interest ratesfrom the first quarter ending cash balance ; and5 . A provision for taxes of approximately $50,000 .

Based on the above assumptions, we estimate diluted earnings per share forthe second quarter of 2004 to be in the range of $0 .02 to $0 .04 based onapproximately 20.8 million weighted average shares .

For the full year 2004, the company is maintaining prior guidance of totalrevenues in the range of $94 million to $97 million, while adjusting the fullydiluted earnings per share guidance to be more in-line with consensusexpectations, with a range of $0 .27 to $0.32 per diluted share, based onapproximately 21 .2 million weighted average shares . As a result of the company'schange in EPS estimates, Digimare is now estimating EBITDA for 2004 to be inthe range of $17 .0 million to $18 .7 million . The change in earning guidance is dueprimarily to anticipated increases in staffing in finance, IT, sales, and marketing,and the costs of compliance with the Sarbanes-Oxley .

120 . Defendant Ranjit repeated Digimarc's false projections for 2004 in a conference

call with analysts or April 29, 2004 .

121 . Defendants ' April 29, 2004 statements regarding anticipated future results were

false and misleading when made as Defendants failed to disclose its 2003 and IQ 04 financia l

results were based on improper and false accounting for expenses and Defendants did not disclos e


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PORTLAND , ORL OO^N 97204TEL . (503) 227-1600 PA > `51 03) 2Z7-6340

that they had manipulated the internal forecasts prepared by Digirnarc's forecasting personnel ,

adding revenues and subtracting expenses from these internal forecasts without any reasonabl e

basis . See ¶ 77-82 above .

122 . On May 10, 2004, Diginiarc filed with the SEC Form 10-Q for 1Q 04, the perio d

ended March 31, 2004, containing the information released to the market in the April 29, 200 4

press release . The IQ 04 Form 10-Q was signed by-Defendant Ranjit, and was certified b y

Defendants Davis and Ranjit pursuant to §§ 302 an d 906 of Sarbanes -Oxley . It is noted (though

not alleged as a "false statement") that on May 10, 2004, Digimarc also announced the

appointment of Michael E . McConnell as Chief Financial Officer and Treasurer of Diginnarc .

McConnell succeeded Defendant Ranjit, who announced his "retirement" as CFO on February

10, 2004, just prior to the disclosure of Digimare's improper accounting and lack of financia l

controls during his tenure .

123 . Defendants' statements regarding Digirnarc's financial performance in 1Q 04 were

false and misleading when made because Digimarc materially overstated its reported earnings by

$1,313,000. During this period, the Company improperly capitalized and failed to expense a total

of more than). $1,500,000 of ordinary payroll and expenses . The false accounting allowed

Diginnarc to report a profit of $525,000, when in fact the Company suffered a loss of $788,000 fo r

this period .

F. DEFENDANTS' FALSE STATEM ENTS REGARDINGDIGIMARC 'S INTERNAL ACCOUNTING CONTROLS

124. Throughout the C lass Period , Defe;ldanits Davis and Ranjit each had an obligatio n

to assure the accuracy of the financial statements included within Digimarc's SEC filings an d


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PORTLAND, OREGON 9720 4TEL (503) 227-1600 FAX (503) 227-6840

financial press releases, including Digimarc's compliance with GAAP and . its stated accounting

policies . Pursuant to § 302(a) of Sarbanes-Oxley, Davis and Ranjit each certified that they had

reviewed Digimarc' .s Form I0-Qs issued during the Class Period and Digimarc's 2003 Form 10-K

before they were filed, that these reports did not contain any misstatements or omissions of

material fact, and that they provided a fair presentation of Digimarc's financial condition at the

time those reports were filed. For example, the certifications signed by Davis and Ranjit stated

that in connection with Digimarc's Form 10-K for the year ended December 31, 2003 states, i n

pertinent part :

4. The registrant's other certifying officers and I are responsible forestablishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and l 5d-15(e) for the registrant and have :

a) Designed such disclosure controls and procedures, or caused suchdisclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known tous by others within those entities, particularly during the period inwhich this report is being prepared ;

b) Evaluated the effectiveness of the registrant's disclosure controlsand procedures and presented ..n this report our conclusions aboutthe effectiveness of the disclosure controls and procedures, as of theend of the period covered by tl s report based on such evaluation ;and

c) Disclosed in this report any change in the registrant"s internalcontrol over financial reporting that occurred during the registrant'

s most recent fiscal quarter (the registrant's fourth fiscal quarter inthe case of an annual report) that has materially affected, or isreasonably likely to materially affect, the registrant's internalcontrol over financial reporting ; and

5 . The registrant's other certifying of cer(s) and I have disclosed, based onour most recent evaluation of internal control over financial reporting, to theregistrant's auditors and the audit con-imittee of the registrant's board of directors(or persons performing the equivalent function :) :


STOLL S'[01-1- L3LRNE LOKEIN", & SHLACIIT R P .C.209 S. W . OAK STREET

PORTLAND, OREGON 97204TEL . (503) 22 -1600 I'AX (503) 227-6840

a) All significant deficiencies and material weaknesses in the designor operation of internal control over financial reporting which arereasonably likely to adversely affect the registrant's ability torecord, process, summarize and report financial information ; and

b) Any fraud, whether or not material, that involves management orother employees who- have a significant role in the registrant'sinternal control over financial reporting .

125 . Davis and Ranjit each signed certifications in connection with Digimarc's Form

I0-Qs for the quarters ended March 31, 2003, June 30, 2003, September 30, 2003 and March 31,

2004. Each of these certifications contain the language quoted in 1 1 124 above, with on e

important exception. The certifications signed by Davis and Ranjit in connection with

Digimarc's Fori i 10-Q for the first quarter ended March 31, 2003, contained the following

additional paragraph which was omitted from the certifications provided by Davis and Ranjit for

the quarters ended June 30, 2003, September 30, 2003 and March 31, 2004 :

6. The registrant's other certifying officer and I have indicated in thisquarterly report whether or not there were significant changes in internalcontrols or in outer factors that could significantly affect internal controls~:ubsequent w- the date of our most recent evaluation, including any correctiveFactions with regard to significant deficiencies and material weaknesses .

126. The omission of the above-referenced paragraph, which appeared in Digirnarc' s

Form l0-Q for 1Q 03, supports the inference that, by 2Q 03 at least, Davis and Ranjit were aware

of internal control problems which had not been. disclosed to investors . That is, they knew

sign>ificant-r;hanges were made but were hiding that fact from the market . Because they did not

want to disclose that there were significant changes, they could not certify that they had indicated

"whether or not" there were significant changes and, thus, they dropped that language from the

certifica: ion .


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)RT LANO, OREGON 9720 4TE1_ . ~i03) 227-?60(' FAX(503)227-6840

127 . Further support for the inference that Davis and Ranjit were aware of interna l

control problems which had not been disclosed to investors by at least 2Q 03 is found i n

Digimarc's own statements regarding "Controls and Procedures" set forth in Item 4 of th e

Company's Form I0-Q for 2Q 03 . Item 4 stated :

ITEM 4. CONTROLS AND PROCEDURE S

As of June 30, 2003 our management evaluated, under the supervision and withthe participation of our Chief Executive Officer and Chief Financial Officer, theeffectiveness of the design and operation of our disclosure controls andprocedures . Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective in timely alerting them to material information required to be included inthis report . Our management also evaluated, under the supervision and with theparticipation of our ChiefExecutive Officer and Chief Financial Officer, anychange that occurred in our internal control over financial reporting during thefiscal quarter ended June 30, 2003 . No such change materially affected, or isreasonably likely to materially affect, our internal control over financial reporting .

The above language not only states that Davis (CEO) and Ranjit (CFO) participated in and

supervised the evaluation of the design and operation of Digimare's disclosure controls and

procedures, it also states that Davis . and Ranjit participated in and supervised the evaluation of

any change that occurred in Diginiarc 's internal controls over financial reporting during 2 Q

03.

128. Significantly, the Company's Form 1 0-Q for the prior period (1Q 03) differ s

materially from the above-quoted language from 2Q 03. Item 4. "Controls and Procedures" in the

Form IO-Q for IQ 03, which also represented that Davis and Ranjit participated in and supervise d

the evaluation of the effectiveness of the design and operation of the Company's disclosur e

controls and procedures, expressly states that "[t]here have been no significant changes in our


STOLI. STOLL BERNE LOKTIN6 & SHLACHTER P .C .209 S .W . OAK STREET

PORTLAND. OREGON 97204TEL. (503) 227-1600 i AX 1503) 227-6840

internal controls or in other factors that could significantly affect internal controls subsequent to

our most recent evaluation of our internal controls ."

129 . Based on the above and the information provided by Confidential Witnesses, it is

clear that Davis and Ranjit did know about changes in Digimare's internal controls over financial

reporting during 2Q 03 . However, investors were falsely assured in Digimarc's Form 10-Q for

2Q 03 that "[n]o such change materially affected, or is reasonably likely to materially affect, our

internal control over financial reporting ." In other words, according to their certifications, there

were no "significant" changes in 1Q 03, while in the second quarter there may have bee n

changes, however, Defendants represented that any such changes did not materially impact the

Company'snancial reporting. Starting in 2Q 03, Defendants dropped the paragraph 6 language

(quoted in 11125 above), which would have required disclosure of any important internal control

changes, and rather falsely assured the market that there were no "significant" changes (i .e . no

"material" changes) . According to Confidential Witnesses, however, the internal control change s

during that period were significant, including the elimination of critical controls over

capitalization of payroll, which was done at Ranjit's direction . (See ¶¶ 67, 68) . This had a

material impact as it enabled the improper capitalization of highly material payroll expenses .

Taken together, the change in the language used by Defendants and the corroborating facts from

former employees, demonstrate that Defendants knew or recklessly disregarded internal control`

changes and problems which had a material impact on the reliability and accuracy of their Class

Period financial statements . The Company's Form 10-Q for the 3Q 03 contained similar false

assurances that there were no "significant" internal control changes, without any specific

disclosure of changes that occurred .


STOLL STOI,' . I3ERNE LOKT NG & SHLA0ITER P .C .209 S .W . OAK STREET

PORTLAND, OREGON 97204TEL. (5031-,27-1600 FAX(503)227-6840

130, Davis' and Ranjit's certifications were also false and misleading when made. As

discussed above, Defendants purposefully eliminated internal control processes designed to

prevent improper capitalization in order to enable the financial statement fraud that occurred . As

alleged above, Defendant Ranjit was personally involved in numerous meetings where the

Company's serious problems accounting for inventory and improper manipulation of inventory

value were addressed . Davis and Ranjit also participated In and supervised the evaluation of

Digimare's internal controls and any change that occurred in the Company's internal control ove r

financial reporting during 2Q 03, as set forth in Digimarc's Form 10-Qs and referenced above .

Importantly, in its 2004 Form 10-K for the year ended December 31, 2004, Digin arc admitted

that it had "material weaknesses" in its internal controls throughout the Class Period. The Form

10-K states :

In connection with our restatement, we identified and reported to our auditcommittee the following areas for improvement in our internal control overfinancial reporting . These matters constitute "material weaknesses" as definedunder standards established by the Public Company Accounting Oversight Boardor "P,CAOB" .

Inadequate supervision and technical accounting expertise within theaccounting and finance department. There was not adequate supervision andtechnical accounting expertise within our accounting and finance department . Thepersonnel resources and technical accounting expertise in the accounting andfinance department were not sufficient to adequately resolve non-routine mattersor complex accounting processes, such as those matters and processes relating tothe recording of software capitalization, standard costing, and revenue recognitionin accordance with U.S . generally accepted accounting principles ("U .S. GAAP") .

Inadequate design and implementation of new accounting system. Thenew accounting system we began to implement in the second quarter of 2002, andwhich was placed in service during the fourth quarter of 2003, was not designed orimplemented properly . There was a lack of accounting expertise within ouraccounting and finance department; as a result our internally developed guidelineswere not properly implemented during the setup and configuration of the new

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STOLL STOL.L BERNE LOKTING & S}iLACI ITER V .C .209 S . W . OAK STREET

PORTLAND, OREGON 9720 4TEL . (5031 227-1600 FAX 1503} 227-6840

accounting system. Implementation of the new accounting system also was flawedbecause some of our accounting and finance employees were not properly trainedin the use of the new accounting system. In addition, the new and old accountingsystems were not operated in parallel prior to the Company's reliance on the newsystem. Running new and old accounting systems in parallel helps validate thatthe new system is correctly recording accounting entries . These implementationissues resulted in errors with respect to fixed assets and inventory, including theduplicate recording of purchases, the capitalization of assets that should have beenexpensed and the expensing of assets that should have been capitalized.

. Inadequate quarterly and year-end financial statement close and reviewprocess . For each quarterly and fiscal year-end period, a financial statement closeand review process occurs . Our staffing for the quarterly and year-end financialstatement close process was not sufficient , and in some instances, we failed tohave adequate management review and supervision over the financial statementclose and review process, including timely reconciliation of inventory , tax andaccounts payable accounts to ensure our financial statements were prepared inaccordance with U .S . GAAP .

Insufficient controls both for determining the nature and types of costs thatshould be capitalized and for ensuring allocation of costs to particular projects areappropriate . Controls for determining the nature and types of costs that should becapitalized in accordance with U .S. GAAP, and for ensuring that costs wer eallocated to appropriate projects, were inadequate, which affected our fixed assetand research and development accounts . We lacked enough personnel withsufficient expertise in complex software capitalization and project accounting rulesunder U.S. GAAP and there was not a clear understanding regarding theapplication of our internal policies in these areas . Some of our employees whoperformed accounting functions were not adequately trained and supervised, andthere were deficiencies in communication between functional departments withinthe Compar:y. Such controls also were insufficient because the documentarysupport for the historical capitalization of certain software development costs andthe system for tracking costs that qualify for capitalization needed improvement,and the detective controls related to the capitalization of internally developedsoftware were not adequate .

. Insufficient controls to ensure that various international tax exposureswere quantified and properly accrued on a timely basis . Internal controls relatedto the quantification and accrual of international taxes incurred by the Companywere insufficient. There was not sufficient staff to properly quantify, accrue, andrecord such taxes on a timely basis in accordance with U .S. GAAP. This affectedour income tax payable and income. tax expense accounts .


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Insufficient training and inadequate reconciliation processes forcomplex revenue recognition requirements primarily related to internationaltransactions . Training and reconciliation process related to complex revenuerecognition requirements regarding distributor discounts, partial deliveries ofgoods and the acceptance criteria for shipped goods were insufficient to ensurethese transactions were recorded in accordance with U .S . GAAP . This affectedour revenue and our deferred revenue accounts .

Insufficient controls related to system access and segregation of duties .Insufficient internal controls resulted in a lack of segregation of duties amongemployees. Users of our new accounting system had access to multiple accountingprocesses within the system instead of only those processes that were theresponsibility of such user. In the absence of such controls, inappropriate orunauthorized journal entries could be entered into the system.

Inadequacies related to entity-level controls . Management has concludedthat there are deficiencies in the design and execution of our entity-level controlsrelating to training, job descriptions, managing of employee turnover, application

of U.S. GAAP, and communication between departments that constitute "materialweaknesses" in our internal control over financial reporting. These deficienciescontributed to the restatement of our previously issued financial statements asdiscussed herein, delays in compliance efforts with Section 404 of the Sarbanes-Oxley Act of 2002 and the rules issued thereunder, and the delayed filing of thisForm 10-K.

Our current management, with the participation of our principal executiveofficer and principal financial officer, carried out a separate evaluation of theeffectiveness of our disclosure controls and procedures (as defined in Rules240.13a-15( .e) and 240.15d-I5(e) of the Securities Exchange Act of 1934) as ofDecember 31, 2004, which included an evaluation of disclosure controls andprocedures applicable to the period covered by the filing of this periodic report .

As noted above, we have identified a number of areas for improvement in ourinternal controls and procedures, as they existed as of December 31, 2004 . Basedon the evaluation of the effectiveness of our disclosure controls and procedures asof December 31, 2004, and subject to the information set forth in this Item 9A, ourprincipal executive officer and principal financial officer have concluded that ourdisclosure controls and procedures were not effective based on the mattersdescribed in this Item 9A.

131 . Defendants Davis and Ranjit either knew about the Company's serious an d

comprehensive break down in internal financial controls or they were deliberately reckless in


STOLL STOLL BERNF LOKTING & SHLACHTER F .C .209 S .W . OAK STREET


certifying throughout the Class Period that they had fully evaluated Digimarc's internal control s

and there were no material weaknesses .

132. In fact, following its January 20, 2004 and February 24, 2004 announcements tha t

Digimare was going to miss the market's revenue and earnings expectations for 4Q 03 ,

Defendants Davis and Ranjit specifically and falsely reassured investors that the Company did not

have serious internal control problems, and in fact was improving its accounting processes an d

controls .

133 . In a conference call with securities analysts on February 24, 2004, Defendan t

Rarijit stated :

Let's get right to the details of those process problems and what has been done toresolve them. During the last few quarters we've been in the process of convertingfrom our Legacy financial accounting and planning systems to a new corporatewide accounting and financial planning system for all financial manufacturing andoperations activities . Going forward we anticipate that this system will greatlyenhance coordination of various aspects of accounting financial planning andforecasting . The accounting system overhaul consolidates all financial planningand reporting functions into a single architecture replacing two incompatibleLegacy systems and various manual processes, For the fourth quarter and full year2003, the company reported earnings which were lower than the revised guidancereleased by the company on January 20, 2004 due to the discovery, during thecompany's closing process and audit, of inventory and accounts payable postingerrors related to the company's new accounting systems . The errors which havebeen identified and corrected led management to overestimate anticipatedearnings-per-share for the fourth quarter and full year 2003 in the company'spreviously released guidance . Prior periods were not affected . Once wediscovered these problems we significantly expanded our coursing and auditprocesses to include a full investigation of the consolidation of all areas impactedby the system conversion. We have taken appropriate steps to correct theproblems created by the system migration during the fourth quarter . We believethat the new accounting systems and processes significantly improve its abilityinto our operations going forward and reduce the risks of such errors .Nevertheless, we plan to take a belt and suspenders approach to financial reportingfor the time being . With enhanced checks and balances and focus to seniormanagement attention. This concludes our discussion of the reasons for th e


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difference between the projected diluted earnings-per-share provided in ourJanuary conference call and final audited results .

134. During the same February 24, 2004 conference call with analysts, Davis als o

reassured investors, stating :

In conclusion, for the past two years, we focused on the bottom line and asdid most of corporate America . These efforts were successful in leading us toprofitability, with our first profitable year behind us we're shifting focus togrowing the top line while continuing diligent cost management . As the leader ofour company I'm very disappointed by the failure to meet guidance in Q4 and thesubsequent uncertainties brought about by problems in our accounting systemconversion. We've carefully studied the causes of the problems and we believewe've taken appropriate remedial action . In addition to addressing the specificproblems that occurred in the quarter we are very committed to continuing toimprove business prophecy across all areas of the business . We see many signs

that our basics bu.iness strategy is working and continue to believe that thepatience of our long-term investors will be rewarded .

135 . Davis' and Ranjit's Februa-y 24, 2004 statements that they had discovered some

limited financial control problems caused by an upgrade in the Company's accounting software

were false and misleading when made . The truth was that Defendant Ranjit was obsessed with

meeting analysts' expectations for the Company and he purposefully set up accounting systems

and processes that enabled the finance department to manipulate improperly Digimarc's financial

statements, and improperly directed his staff to do what was necessary so that Digimarc's

reported eamings met the unrealistic and unattainable projections Digimarc provided to the

market. as described herein . Digimarc had serious and comprehensive internal control an d

accounting problems both before and after Defendants' February 24, 2004 statements .

13 6, Digimarc's 2003 Form 10-K for the year ended December 31, 2003 further stated :

Evaluation of disclosure controls and procedures . Our managementevaluated, with the participation of our Chief Executive Officer and our ChiefFinancial Officer, the effectiveness of our disclosure controls and procedures as o f


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the end of the period covered by this Annual Report on Form I 0-K . Based on thisevaluation, our Chief Executive Officer and our Chief Financial Officer haveconcluded that there were significant deficiencies in the design and operation ofour internal. controls that adversely affected our ability to record, process,summarize and report financial data in a timely manner. However, thedeficiencies were not considered to be material weaknesses under the standardsestablished by the American Institute of Certified Public Accountants . Thedeficiencies related to our ability to properly design and test the functionality ofcertain aspects of a new accounting and material requirements planning ("MRP")system and our ability to complete our year-end financial close process withoutadjustments proposed by our independent auditor .- Affected areas included thecalculation of inventory values due to issues surrounding units of measure,standard costs, and reconciliation of physical counts to perpetual records andgeneral ledger balances, as well as the posting of accounts payable transactions tothe general ledger and the associated reconciliation process . The deficiencies didnot affect our reported financial results .

Changes in internal control over financial reporting . As a result of theconclusions discussed above, under the direction of the Audit Committee and theBoard of Directors, we have taken corrective action to strengthen our internalcontrols and procedures to ensure that information required to be disclosed in thereports that we file or submit under the Securities Exchange Act of 1934, asamended, . is recorded, processed, summarized and reported accurately within thetime periods specified in the SEC's rules and forms . Specifically, in order toensure the functionality of the newly implemented accounting and MRP system isdesigned and tested properly, we have hired additional finance and accountingpersonnel with experience in this area . In addition, we have reallocatedresponsibilities and adjusted our resources to address the issues related to ourreconciliation process . We have also established a task force to document failuresin the established processes and the actions necessary to correct the identifiedprocess fa?lure .s .

137 . Defendants' statements in its 2003 Form 10-K that the Company had no material

weaknesses in internal financial controls and that the deficiencies in the Company's interna l

controls had no effect on the Company's reported financial results were false and misleading

when made . As detailed above, the Company had numerous material weaknesses in its internal

control systems resulting in improper capitalization of ordinary expenses and material

misstatements of the Company's financial results throughout 2003 and first quarter of 2004 .

Page 68 SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LAW

STOLL STOLL BERNE LOKT![v(i & 5111LAC[[`CGR P .C.209 S.W. OAK STREE T

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138 . Defendants Davis and Ranjit certified that they personally performed evaluations

of Digimarc's internal controls in connection with all of Digimarc's SEC filings during the Class

Period, including the Company's Form 10-Qs for the fiscal periods ended March 31, 2003, June

30, 2003, and September 30, 2003 and the 2003 Form 10-K, and thus they must have known of

these extensive material weaknesses . If they did not low, then their certifications of Digimarc' s

internal controls were deliberately false or made with deliberate recklessness .

DEFENDANTS REVEAL DIGIMARC'S TRUEPRECARIOUS FINANCIAL CONDITIO N

139. On July 28, 2004, Digimarc released its financial results for the second quarter o f

2004, the period ended June 30, 2004 ("2Q 04"), announcing :

Digimare's total revenue for the second quarter was $23 .7 million, or 5%

higher as compared to the $22 .5 million reported in the comparable period of 2003and 1% higher as compared to the $23 .5 million reported in the previous quarter .

The company reported a net loss of $1 .9 million, or net loss per basic and diluted

share of ($0 .10) based on 20.28 million basic and diluted weighted average shares

outstanding for the quarter . This compares with net income per basic and diluted

share of $0 .02 for the comparable period of 2003 and 50 .03 for the previous

quarter. Total operating expenses were 89 .7 million as compared to $10.1 million

for the comparable period of 2003 and $9 .4 million for the previous quarter .

Earnings before Interest, Taxes, Depreciation and Amortization ("EBITDA") was$1 .1 million for the second quarter of 2004 compared to $3 .3 million for thecomparable Period of 2003 and $3 .2 million for the previous quarter . . . .

Digimare's total revenue for the six-month period of 2004 was $47 .2

million, or 7% higher as compared to the $44 .3 million reported in the comparable

period of 2003 . The company reported a net loss of $1 .4 million, or net loss per

basic and diluted share of ($0.07) based on 20 .24 million basic and dilutedweighted average shares outstanding for the six-month period ended June 30,2004. This compares with net income per basic and diluted share of $0 .02 for thecomparable period of 2003 . Total operating expenses were $19 .1 million as

compared to $19 .9 million for the comparable period of 2003 . EBITDA was $4 .3

million for the six-month period of 2004 compared to $6 .0 million for the

comparable period of 2003 .


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The. lower than expected earnings per share for the second quarter of2004 was due primarily to lower than expected gross margin . The company'sgross margin was 33 % for the second quarter of 2004 compared to 45% for thesame period in 2003 and 42% in the previous quarter. A number of factorscontributed to the gross margin variance, including inventory charges, variancesto expense forecasts, and an unfavorable revenue mix . Specifically, thecompany recorded inventory reserves related to product life cycles andimpairment charges for spare parts on hand deemed to be in excess of factureusage needs; incurred unplanned production start-up yield losses and higherthan expected delivery costs for services provided; and, experienced a revenuemix change from expected higher-margin consumables sales to lower-marginadd-on and equipment sales.

Company management estimates for the third quarter of 2004 are :

1 . Total revenues in the range of $22 .0 million to $23 .0 million ;2 . Gross margins in the range of 40 to 42 percent ;3 . Total operating expenses of $10 .5 million to $11 .0 million ;

4. Other income, consisting mainly of interest income, of approximately$145,000; and5 . A provision for income taxes of approximately $60,000 .

Based on the above assumptions, we estimate a loss per share for the thirdquarter of 2004 in the range of ($0.03) to ($0 .06) based on approximately 20 .40

million weighted average shares . Also, we expect EBITDA in the range of $1 .5

million to $2 .5 million .

For the full year 2004, the company is maintaining prior guidance for totalrevenues in the range of $94 million to $97 million . We are not currently offering

full year BPS guidance .

140. Commenting on the Company's results, Defendant Davis, said :

Our disappointing financial results relate primarily to our ID Systems businessunit and call for decisive action to improve the efficiency, effectiveness, andpredictability of operations. In addition to beefing up our finance and ITresources, I have asked Paul Gifford, Digimarc's President and COO, toimmediately assume direct control and responsibility for the ID Systems business .Paul will commit himself full-time to ID Systems and will lead the business unituntil we are satisfied that the operational issues are fully resolved . During thisperiod, I will assume direct management responsibility for all other areas of ourbusiness .

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STOLL STOLL BERNE LOKTING & SULACHTER P .C .209 S .W. OAK STREE T


141 . Newly named CFO Michael McConnell stated :

We addressed many issues during the quarter. As we continue to expandthe use of the new accounting and MRP system put in place in late 2003, we arepleased that the information we are receiving is more timely and in greater depththan previously available. This allows us to perform detailed analyses with muchmore operational relevance . In addition, our Sarbanes -Oxley efforts to document

and improve our controls and processes, along with key personnel additions tothe finance team , are seeing immediate benefits. The results we are reporting

for the second quarter are disappointing, but we believe the improved processeswe have put in place have greatly enhanced our ability to identify operational

improvements .

142. The Company's July 28, 2004 announcement corrected the market 's misperceptio n

of Digimarc as a successful company with growing profits that was created by Defendants false

and misleading statements set forth above . As the D.A. Davidson & Co. senior research analyst

Bill Frerichs stated, "Digimarc's management and financial control issues appear to b e

snowballing . . . ." Thus, the July 28, 2004 announcement clarified to the market that Digimarc was

a company with serious internal control and financial reporting issues and significant losses .

Analysts fro n Morgan Keegan & Co., D .A. Davidson & Co . and Janney Montgomery Scott, LLC

all downgraded the Company the next day . In response to Defendants' July 28 statement, the

artificial inflation created by Defendants' prior false statements was eliminated . Immediately

following the Company's July 28, 2004 release, Digimarc's stock fell significantly, from its

closing price of $12.07 on July 28, 2004, to a closing price of $9 .04 on July 29, 2004, on usually

high trading volume of 653,600 shares .

143 . On September 13, 2004, the Company issued a press release entitled "Digimarc

Corporation Announces Review of Accounting Treatment Regarding Capitalization of Certai n


STOLL STOLL BERNE LOKTING & S1-ILACHTER P .C.209 S .W . OAK STREE T

ORTLAND, OREGON 97204TEL . 1, 503) 227-1600 PAX (503) 227-6840

Expenditures: Advises That Prior Period Financial Statements May be Restated ." It stated, in

relevant part :

Digimare Corporation today announced that it is reviewing certain accountingpractices and previously reported financial statements as a result of possible errorsdiscovered by management of the Company in the accounting, for software

development costs and project capitalization at its Digimarc ID Systems businessunit . Management has presented its preliminary findings to members of theCompany's audit committee and, in consultation with and under the supervision ofthe Company's audit committee, will be continuing its review of the Company'saccounting for software development and project costs at ID Systems .

Management's preliminary assessment is that certain software developmentcosts have been improperly capitalized . These possible errors are estimated to bein the range of approximately $1 .2 million to $2 .0 million and may require arestatement of prior period financial statements from 2002 to 2004 .

Management is also reviewing other project cost capitalizationaccounting practices of ID Systems and this review may also result in additionaladjustments which may affect prior periods . These potential additionaladjustments, if necessary, are currently estimated not to exceed $1 .5 million .

The impact of these possible errors on prior and current period financialshas not been determined, but it is expected that if a restatement is required, itwould negatively affect reported historical results . Regardless of whether there isa restatement, the Company may incur current period charges from some of theseitems as well as costs associated with its accounting review and any requiredrestatement . Accordingly, due to the current uncertainty regarding the amount ofthese costs and charges, the Company is withdrawing its previously issuedguidance for the third quarter except with respect to anticipated revenue .

Management currently believes that restatement of its results for the firsttwo quarters of 2004 and for the full year of 2003 is likely to be required .Accordingly, the Company's previously reported;fnancial statements for full ~--. f scal year 2003 and the first two quarters of 2004 should no longer be relie dupon until such time as the Company completes its review . The Company has notyet reached a conclusion as to whether the impact on quarterly periods within 2003and periods prior to 2003 will warrant a restatement of the financial statements forthose periods . As soon as practicable following the completion of its review, theCompany intends to announce its final conclusions regarding these accountingissues and, if necessary, file any amendments to its previous filings with theSecurities and Exchange Commission that may be required.


STOLL STOLi_ BERM I0ICTLNG & SHLACHTER P .C .209 SW . OAK R}:F T

PORTLAND (E PGON 9720 43 "". . (503)22-1-J(,00 rA K (503) 22;-6540

Management identified the potential accounting errors with respect toDiginnarc ID Systems as part of its previously reported process of implementingadditional controls and procedures . As part of this ongoing review, which is beingoverseen by the Company's new Chief Financial Officer, management hasidentified additional control and process weaknesses in connection with therecently discovered accounting errors, and is in the process of implementingenhanced controls and procedures to address these weaknesses .

144 On November 8, 2004, the Company issued a press release entitled "Digimarc

Expects Delay in Filing 10-Q for Third Quarter: Delay due to continuing work on previously-

announced accounting review ." This press release stated in relevant part :

Digirnarc Corporation today announced that the filing of its Form 10-Q for thequarter ended Sept. 30, 2004 will be delayed beyond the Securities and ExchangeCommission's filing deadline of November 9, 2004 in order to provide additionaltime for the Company and its independent auditors to finalize a review ofaccounting for software development and project costs at its Digimarc ID Systemsbusiness unit .

As soon as practicable following the completion of its accounting review,the Company intends to announce its final conclusions regarding its accountingissues arid, as applicable, file amendments to certain of its previous filings with theSecurities and Exchange Commission . The filing of the Company's Form 10-Qfor the quarter ended Sept . 30, 2004 will be delayed pending the filing of suchrestatements of historical financial statements .

As a result of the Company's delay in filing its Form 10-Q for the quarterended Sept . 30, 2004, the Company expects to receive a standard notification fromNasdaq that it is not in compliance with the filing requirements for continuedlisting on Nasdaq and that its securities may be subject to delisting from the

Nasdaq National Market . In addition, if the Company receives such notification, ----the Company anticipates that Nasdaq will add a fifth character, "E", to th eCompany's trading symbol "DMRC . . . . "

The Company also announced that it is continuing its review,implementation and testing efforts under Section 404 of the Sarbanes-Oxley Act of2002, including enhanced staff and consulting resources . However, the focusedapplication of critical resources to the Company's on-going accounting review andthe preparation of amended filings and ancillary documents are having asignificant impact on its Section 404 compliance efforts .


STOLL S"P OLL BERME LOKTIN :, & SHLACHTTR P.C .209 S .W . OAK STRr T

. ORTLAND, OREGON 9720 4TEL . (503) 227 .1500 F' X (503) 227-6&40

The Company and its audit committee have notified, and engaged in initialdiscussions with, the Company's independent auditors regarding the foregoingmatters but no conclusions have yet been reached. The Company is workingclosely with the Company's independent auditors to address these matters .

145. On November 12, 2004, Digimarc issued a press release entitled "Digimarc

Receives Delisting Notification from Nasdaq as Previously Announced : Company to reques t

hearing on plan to regain compliance ." This press release stated in relevant part :

Digimarc Corporation today announced that, as previously announced, the delay inthe filing of its Form 10-Q for the quarter ended Sept . 30, 2004 has resulted in adelisting notification from Nasdaq indicating that the Company failed to complywith filing requirements for continued listing set forth in Marketplace Rule4310(c)(14) . The Company is requesting a hearing before a Nasdaq ListingQualifications Panel to discuss its plans to achieve compliance with corporatefiling and listing requirements .

The Company's hearing request will automatically stay the delisting of theCompany's securities pending the Panel's decision . In the meantime, theCompany and its independent auditors are continuing to work to finalize a reviewof accounting for software development and project costs at the Company'sDigimarc II) Systems business unit .

Asa result of these circumstances, Nasdaq added at the opening ofbusiness on Nov . 12, 2004 a fifth character, "E", to the Company's trading symbol"DMRC . "

146: On January 27, 2005, Digimarc issued a press release entitled "Digimarc Receive s

Extension from Nasdaq Listing Qualifications Panel to Regain Compliance with Listing

Requirements ." In pertinent part, this press release stated :

Digimarc Corporation today announced that on January 24, 2005, the Companyreceived a notice from the Nasdaq Listing Qualifications Panel granting theCompany until February 15, 2005 to file its Forth 10-Q for the third quarter of2004. The Panel's decision establishes the tiniefiame for the Company to regaincompliance with the requirements for continued listing . The Company expectsthat it will file its Form 10-Q for the quarter ended September 30, 2004 inaccordance with the terms of the Panel's decision . The extension granted by thePanel is subject to the Company's continuing compliance with other requirementsfor listing on the Nasdaq National Market .


STOLL STOLL BEERNE LOKTING & SHLACHTER P .C .

209 S .W . OAK STREETPORTLAND, OREGON 97204

TEL. (503) 227-1600 FAX (503) 227-6840

147, On February 14, 2005, Digimarc issued a press release entitled "Digimar c

Corporation To Align Filing of Third Quarter Form I0-Q With Filing of Form 10-K for Year

Ended December 3 11 . 2004: Nasdaq Extends Filing Deadline for Form I0-Q ." This press releas e

stated in relevant part :

Digimarc Corporation today announced that the Nasdaq Listing QualificationsPanel has granted the Company's request to extend the current deadline ofFebruary 15, 2005 to March 1 6 , 2005 to file the Company's Form 10-Q for thethird quarter of 2004 . The Company sought the extension in order to align thefiling of its Form 10-Q for the third quarter of 2004 with the filing of its Form 10-K for the fiscal year ended December 31, 2004. The Company's deadline for ~-filing the Form 10-K is March 16, 2005 . The Company expects to issue it srestated financial statements for 2003 and 2004 concurrently with the completionof its financial statements for the nine months ended September 30, 2004 and forthe year ended December 31, 2004 .

148 . On March 17, 2005, Digimarc issued a press release entitled "Digimarc

Corporation Provides Preliminary Estimates of Restatement Adjustments and 2004 Financial

Results : Company seeks 15-day extension from Nasdaq to complete audit and file 2004 financia l

statements ." This press release stated, in pertinent part :

Digimarc Corporation today announced preliminary estimates for adjustments toprior period financial statements and for fiscal year 2004 financial results . TheCompany also announced that it will file for the automatic 15-day extension, asprovided under SEC regulations, for filing its Form 10-K 2004, and that it isseeking a.. 15-day extension from Nasdaq to extend the deadline to file theCompany's Form 10-Q and Form 10-K until March 31, 2005 . The Nasdaq Panelhad previously granted the Company's request to extend the deadline for filing theForm 10-Q for the third quarter of 2004 to March 16, 2005 to align the Form 10-Qfiling with the filing of its Form 10-K for the fiscal year ended December 31,2004 .

The preliminary estimates of the restatement adjustments and financialperformance data set forth below are unaudited preliminary numbers, which arebeing provided subject to completion of the Company's analysis, and th econtinuing review and audit by our independent registered public accounting firmand ,the Company.' s audit committee . Thus, the final audited results may vary


STOLL S'''OLL I3L.RNE: LOKTING & SULACHTER P .C209 S . W . OAK S'I'R. PET

PORTLAND, OREGON 9720 4TEL . 1503) 227-1600 FAX (503) 227-6840

materially from these estimates . All references in this press release to financialresults for 2003, for individual quarters within 2003 and for the first two quartersof 2004 refer to the Company's preliminary estimates of such results after givingeffect to the Company's restatement. Highlights of the Company's anticipatedfinancial results include :

• Full year 2004 revenues increased 9% to approximately $93 million, comparedwith revenues of approximately $85 .5 million in 2003 ;

• Full year 2004 net loss is estimated at approximately $9 million, comparedwith 2003 net income that was approximately break even ;

• Fourth quarter 2004 revenues increased 15% to approximately $22 million,with a net loss of approximately $4 .6 million, compared with fourth quarter2003 revenues of approximately X19 million and net loss of approximately$600,000 ;

• Third quarter 2004 revenues increased 5% to approximately $23 .5 million,with a net loss of approximately $2 .5 million, compared with third quarter2003 revenues of approximately $22 million and net income of approximately$500,000 ;

• Cash, cash equivalents, restricted cash and short term investments balance asof December 31, 2004 was approximately $52 million ;

• Restatement adjustments are limited to 2003 and first two quarters of 2004 ;

• Collective impact of the restatement will be to increase the company's reportednet loss over the periods affected by approximately $2 million, which is belowthe midpoint of previous estimates of $1 .2 to $3 .5 million ;

• Company incurred third-party accounting and legal fees of approximately $2million through December 31, 2004 related to the review and restatement ofprior periods and Sarbanes-Oxley compliance activities ; and

• Shares outstanding at December 31, 2004 were approximately 20 .5 million .

Preliminary Estimates of Full Year 2004 Results Compared to Restated Fiscal2003 Results

The Company anticipates total revenue for the twelve months endedDecember .31, 2004 of approximately $93 million, compared with revenues ofapproximate ly $85 .5 million for the year ended December 31, 2003. TheCompany.also anticipates a net loss of approximately $9 million , or approximatel y

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SFOL L, STOLL BERNE LOKTLNG & SHLAC:HTE:;R P.C .209 SW . OAK STREET


$(0 .44) per basic and diluted share, for 2004, compared with anticipated results for2003 that are approximately break even .

Preliminary Estimates of Fourth Quarter 2004 Results Compared to RestatedFourth Quarter 2003 Results

The Company anticipates revenue for the fourth quarter of approximately$22 million, 15% higher than revenues of approximately $19 million generated inthe comparable .period of 2003 . The Company anticipates reporting a net loss ofapproximately $4 .6 million, or approximately $(0 .23) per basic and diluted share .In the comparable prior year period, the Company anticipates reporting a net lossof approximately $600,000, or approximately $(0 .03) per basic and diluted share .

Preliminary Estimates of Third Quarter 2004 Results Compared to RestatedThird Quarter 2003 Results

The Company anticipates third quarter 2004 revenues of approximately$23 .5 million, approximately 5% higher than revenues of approximately $22.3million generated for the comparable period of 2003 . The Company anticipatesreporting a net loss of approximately $2 .5 million, or approximately $(0 .12) per

basic and diluted share, compared with net income of approximately $800,000, or

approximately $0 .04 per basic and diluted share for the third quarter of 2003 .

Restatement Process

As announced on September 13, 2004, the Company identified potentialerrors in its accounting for software development costs and project capitalization atthe Company's ID Systems business unit and postponed the release of its financialresults for the quarter ended September 30, 2004, pending a review of theCompany's prior accounting . The Company's resulting review focused on thecapitalization of software development and project accounting. As errors in theseareas were identified and corrected, the Company determined that it was prudent toexpand its review to additional areas of its financial statements . As a result, theCompany has investigated the balances in all major accounts within theCompany's financial statements

. This extensive review resulted in estimated adjustments that will reduceincome by approximately $2 million, which is below the midpoint of theCompany's previous estimate of $1 .2 million to $3 .5 million . The Companyanticipates the adjustments will affect its financial statements for the fiscal yearended December 31, 2003, including each of the quarterly periods in that year, andthe quarterly periods ended March 31, 2004 and June 30, 2004 . During thereview, the Company made and will continue to make improvements in it sf tiancial controls to address the areas that were identified as needin g


STOLL S"1'! )I.L BERNF LOKTING & SHLACHTER P .C .209 SAW . OAK STREE T

PORTLAND . OREGON 97204TIC1- (503) 227 .1600 !'AX (503) 227-6840

improvement. Details regarding the affected accounts, timing of the adjustments,areas identified as needing improvement, and remedial actions taken will be setforth in detail in the Form 10-K for 2004 that the Company expects to file prior tothe end of March 2005 .

Anticipated Results of Restatement of 2003 and First and Second Quarters of2004

As previously announced, the Company will restate Financial results for2003 and the first two quarters of 2004 primarily to correct certain errors in theaccounting for the capitalization of costs related to internal use software and inproject accounting at the Company's ID Systems business unit . The accounting

errors to be corrected in the restatement include the following :

• certain software development costs relating to internal-use software at theCompany's ID systems business were erroneously capitalized ;

• errors in the implementation of a new accounting system in 2003 and early2004 resulted in mistakes in various project costs, inventory and relatedaccounts ;

• certain international tax expenses were not recorded in a timely manner ; and

• in two instances, revenue accruals were not recognized in a timely manner withrespect to certain long-term production contracts because the estimatedproduction volumes and actual production volumes were not reconciled .

An overview of estimated adjustments by period follows :

• First quarter of 2004 - Restated revenues for the first quarter of 2004 wereapproximately $23 .7 million compared with $23 .5 million as initially reported .

Restated net toss was approximately $600,000, or ($0 .03) per share, compared

with net income of $525,000, or $0 .03 per share, as initially reported .

Second quarter of 2004 - Restated revenues for the second quarter of 2004 ..--

were approximately $23 .5 million compared with $23 .7 million as initiall y

reported. Restated net loss was approximately $1 .5 million, or ($0 .07) per

share, compared with a loss of $1 .9 million, or ($0 .10) per share, as initially

reported .

• Fiscal Year 2003 - Restated revenues for 2003 were approximately $85 .5million, reflecting no material change in revenues for the year from thosein.itiall-ly reported. Restated operating results are approximately break even,compared with net income of $1 .5 million, or $0 .08 per diluted share, as


SPOLL STOLL HERNF. LOKTING & SHLACHTER P .C .

209 S W. OAK STREETPORTLAND, OREGON 97204

TEL (503) 227-1640 EAX (503) 227-6840

initially reported .

149. On March 23, 2005, the Company issued a press release entitled "Digimar e

Receives Further Extension from Nasdaq Listing Qualifications Panel to Regain Compliance wit h

Listing Requirements ." This press release stated , in relevant part :

Digimarc Corporation today announced that the Nasdaq Listing QualificationsPanel has granted the Company's request to extend the current deadline to file boththe Company's Form 10-Q for the third quarter of .2004 and Fonn 10-K for theyear ended December 31, 2004, including all required restatements of prior periodfinancial results . The Panel's decision extends the deadline from March 16, 2005to March 31, 2005 for the Company to file its Form 10-Q and Form 10-K .

150 . On April 1, 2005, Digimarc issued a .press release entitled: "Digimarc Corporatio n

Delays Filing of Form 10-K." In relevant part, this press release stated :

Digimare Corporation today announced that the filing of its 2004 Form 10-K and

Third Quarter 2004 Form 10-Q will be delayed beyond March 31, 2005 in order to

complete its review of and revisions to the draft filings and provide its independentregistered public accounting firm, KPMG LLP, additional time to complete : their

documentation and related audit procedures for their audit of the Company's

financial results .

The Company expects to file its 2004 Form 10-K and Third Quarter 2004Forin 10-Q within a few business days of the date of this release. The Form 10-Kwill not include management's assessment of internal control over financia lreporting under Section 404 of the Sarbanes-Oxley Act, which it intends to providein an amended Form 10-K/A on or about May 1, 2005 . Due to continuing delay inmaking these filings, the Company has requested that Nasdaq provide a furtherextension of the current deadline in its delisting proceeding until the Company'sForm 10-K and Form 10-Q are submitted .

151 . On April 5, 2005, the Company issued a press release entitled "'Digimarc

Corporation Announces Financial Results for 2004 and Anticipated Effect of Prior Perio d

Restatements ." This release stated, . in relevant part:

Digimarc Corporation today announced its anticipated financial results for 2004and anticipated effect of restatements of prior period financial statements . TheCompany's unaudited financial results for fiscal year 2004, and anticipate d

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STOLL STOLL BERNE LOK!'Pk ; & s11L.ACFITER P .C209s .W .OAY s9REE r

Mo TLANC . O EQON 97204

TEL . 009 227-1600 i;AX (.503) 227-6844

adjustments to certain prior period financial statements in 2003 and 2004, areconsistent. with the preliminary results announced by the Company on March 17,2005 . All references in this press release to financial results for quarterly andyearly results for 2003 and quarterly results for the first two quarters of 2004 referto such results after giving effect to the anticipated restatement and all referencesto the restatement or to restated financial results shall mean the anticipatedrestatement or anticipated restated financial results, as the case may be . Allfinancial results and other financial information in this press release are unauditedand are being provided subject to continuing review and audit by our independentregistered public accounting firm and the audit committee of our Board ofDirectors . The Company expects to file audited final numbers in its Form 10-Kfor the year ended December 31, 2004 within the next several days and does notexpect there to be material changes from the unaudited financial results containedin this press release .

Highlights of the Company's financial results include:

• Full year 2004 revenues increased 9% to $92 .9 million, compared withrevenues of `x85 .6 million in 2003 ;

• Full year 2004 net loss was $9.0 million , compared with 2003 net income of$0.2 million ;

0 Fourth quarter 2004 revenues increased 3 7% to $22.3 million, with a net lossof $4.5 million, compared with fourth quarter 2003 revenues of $19 .() millionand net loss of $0 .6 million ;

• Third quarter 2004 revenues increased 5% to $23 .5 million, with a net loss of$2 .5 million, compared with third quarter 2003 revenues of $22 .3 million andnet income of $0 .8 million ;

• Cash, cash equivalents, restricted cash and short term investments balance asof December 31, 2004 was $51 .8 million ;

• Restatement adjustments were limited to 2003 and to the first two quarters of2004 and the collective earnings impact of prior period restatements was toincrease the Company's reported net loss over the affected periods by $2.0pillion (a recap of these adjustments are provided at the end of this release) ;

• The Company incurred third-party accounting and legal fees of approximately$2 .2 million 'through December 31, 2004 related to the review and restatementof prior periods and Sarbanes-Oxley compliance activities .

Page ~ 0 - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LA W

STOLL STOLL BERNF F,OKT'-NG & SI-ILACHTER P .C.209 S.W. OAK STREE T

PORTLAND, OREGON 97204TE 1. . (503) 22

7-1600 FAX(503)227-6840

Full Year 2004 Results Compared to Restated Fiscal 2003 Results

Total revenues for the twelve months ended December 31, 2004 were$92.9 million, compared with revenues of $85 .6 million for the year ended

December 31, 2003 . Gross margin was 38% in 2004 compared with 45% in 2003,reflecting increased inventory and program asset charges, increased internationaloperations costs, lower-margin revenue mix and higher depreciation charges .

Operating expenses totaled $45 .0 million in 2004, compared with $38 .7 million in2003, primarily due to increased general and administrative costs which included

$2.2 million of third-party accounting and legal fees incurred in conjunction withthe Company's review and restatement of prior periods and Sarbanes-Oxleycompliance activities . Sales and marketing and R&D expenses in 2004 werecomparable to those incurred in 2003 . The Company reported a net loss of $9 .0

million, or $(0 .44) per basic and diluted share, for 2004, compared with virtuallybreakeven restated results for 2003 .

Fourth Quarter 2004 Results Compared to Restated Fourth Quarter 20 .03

Results

Revenue for the fourth quarter of 2004 totaled $22 .3 million, 17% higher

than revenues of $19.0 million generated in the comparable period of 2003 . TheCompany reported a net loss of $4 .5 million, or $(0 .22) per basic and diluted share

for the fourth quarter of 2004 . In the comparable prior year period, the Companyreported a, net loss of $0 .6 million, or $(0 .03) per basic and diluted share .

Third Quarter 2004 Results Compared to Restated Third Quarter 2003 Result s

Third quarter 2004 revenues totaled $23 .5 million, 5% higher than

revenues of $22 .3 million generated for the comparable period of 2003 . The

Company reported a net loss of $2 .5 million ; or $(0 .12) per basic and diluted sharefor the third quarter of 2003, compared with net income of $0 .8 million, or $0 .04per basic and diluted share for the third quarter of 2003 .

Restatement of 2003 and First and Second Quarters of 200 4

As previously announced, .the Company restated financial results for 2003and the first two quarters of 2004 primarily to correct certain errors in accountingfor the capitalization of costs related to internal use software and in projec t

accounting at the Company's ID Systems business unit . After an extensivereview, the Company made adjustments that reduced net income over the periodsaffected by $2.0 million, consistent with the Company's preliminaryannouncement on March 17, 2005 .

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STOLL STC'LL BERNF LOKTIM ; & SHLAC:HTER P .C .2.09 C .W, OAK STREET

PORTLAND, OR0 ,ON 9720 4TEiL. (503) 227-1600 FAX(503)227-6840

Non-Compliance With Nasdaq Listing Requirements

The Company has not yet filed its Form I0-K for the year ended December31, 2004 and its Form 10-Q for the quarterly period ended September 30, 2004,which were required to be filed by March 31, 2005 in order to meet the NasdaqListing Qualifications Panel's filing deadline set forth in its decision on March 22,2005 to provide the Company additional time to file both the Company's Form 10-Q for the third quarter of 2004 and Form 10-K for the year ended December 31,2004, including all required restatements of prior period financial results . TheCompany currently expects to file its Form 10-K for the year ended December 31,2004 and its Form 10-Q for the quarterly period ended September 30, 2004 withina few days . The Company has notified Nasdaq about the delay and requested thatthey continue the listing of Digimarc's shares . The Company cannot provide anyassurances that they will grant its request.

Reinediation of Accounting Issues

As announced on September 13, 2004, management identified errors in theCompany's accounting for software development costs and project capitalizationas a result of a review of the Company's accounting and a review of th eCompany's internal control over financial reporting under Section 404 of theSarbanes-Oxley Act of 2002 . While the Company's initial review focused on thecapitalization of software development and project accounting costs, as errors inthese areas were identified and corrected, the Company determined that it wasprudent to expand its review to additional areas of its financial statements . As aresult, the Company investigated the balances in all major accounts within theCompany's financial statements .

Over the course of this process, the Company identified and reported to itsaudit committee a number of areas for improvement in accounting processes andinternal controls . These matters constitute "material weaknesses" as defined instandards established by the Public Company Accounting Oversight Board.Identified areas for improvement in internal controls include inadequate orinsufficient technical accounting expertise, design and implementation of a newaccounting system, financial statement close and review processes, determinationand allocation of costs that may be capitalized, international tax accruals,reconciliation processes for complex revenue recognition, system access andsegregation of duties, and entity level controls .

Sarhanes-Oxley 404 Assessment and Improvement of Internal Controls

The Company is making progress but has not yet completed itsimplementation of compliance ob ligations under Section 404 of the Sarbanes-

Oxley Act . The Company continues to work on the required testing an d


STOLL STOLL BERNE LOKTINC & SHLACU7'CR P .C.

209 S .W . OAK STREE TPORTLAND . OREGON 97204

TEL . (503) 227-1600 FAX (503) 227-6540

assessment of its internal control over financial reporting, and intends to providethe report of management's assessment of internal control over financial reportingas of December 31, 2004, and the attestation report of KPMG LLP in a n

amendment to its Form 10-K on or about May 2, 2005 . Based on the materialweaknesses identified during 2004, it is probable that both management'sassessment and KPMG LLP's report will conclude that the Company's internalcontrol over financial reporting was not effective as of December 31, 2004.

The Company believes that the material weaknesses identified throughoutthe extensive review of its 2003 and 2004 financial statements have been or are inthe process of being remedied, and that the consolidated financial statementscontained in this press release fairly present its financial position and results ofoperations for 2003 and 2004 in all material respects .

Digimarc CorporationRestatement Totals for the Six QuartersBeginning Q 12003 and Ended Q2 200 4

(in 000's)(Increase)/Decrease in Earning s

Capitalisation ofSoftwar e

Project A.ccoasting

Revenue

Income Taxes

Other

03 Q J 03 Q2 03Q3

149 2299 33 1

15 81

30 (52) 30

------------------- --------------- ---------------

'79 191 442

------- ------------ - -------------- ----------------

03 04 04 Tota lQ4 Q1 Q2

229 404 340 1,68 1

357 1,146 (836) 764

- (280) 193 (87)

30 - (38) -

(73) 43 (334) (365)

543

---------

1,31 3

----------

(675 )

----------------

1,993

---------------

# ofTotal

84%

38%

•4%

0%

-181/16-

100%

Description ofAdjustnents.

Capitalized software development costs . We produce software that is usedinternaily, and as such have costs that qualify under the American Institute of


STOLE STOLL BERNE I..OKT1NG & SF1LACIFrrER P .C .209 S .W. OAK STREE T


Certified Public Accountants' Statement of Position (SOP) 98-1 , Accounting forthe Costs of Computer Software Developed or Obtained for Internal Use. Thepolicy requires expensing of activities related to the preliminary stage of asoftware project (such as the conceptual formulation of alternatives), allowscapitalization of activities related to the application development stage of asoftware project (such as coding, installation, and testing), and requires expensingof activities related to the post-implementation stage (such as training,maintenance, and support) . Under these rules we capitalize costs in the applicationdevelopment stage of a software project. In connection with the restatement, wedetermined that certain costs had been erroneously capitalized because either aportion of such costs did not qualify . for capitalization (e .g., costs related to thepreliminary or post-implementation stages) or the project itself did not qualify asinternal-use software (e .g_, costs related to a non-software project) .

Project accounting cost tracking and cost deferrals . We erroneouslytracked costs for various projects as a result of certain difficulties we hadimplementing a new accounting system in late 2003 and early 2004, As a result,certain costs that should have been recognized as expenses in the period incurredwere erroneously recorded as inventory or as fixed assets .

Revenue accrual based on estimated production . We recognize revenueon long-term identification and driver license production contracts using a price-per-card method. We use actual monthly volume amounts, if available .Otherwise, we estimate the card production volume on a monthly basis for certainof these contracts in order to recognize revenue earned during the period . In thecase of estimates, prior to publicly reporting results, our practice is to compare theactual production volumes to estimated production volumes and adjust revenueamounts as necessary. However, for the first and second quarters of 2004, thispractice was not followed and, as a result, we understated revenues during the firstquarter of 2004 and overstated revenues for the second quarter of 2004 .

Income tax accrual tinting . We identified certain international taxexpenses that had not been properly accrued in the period incurred .

Other. Other adjustments were made in the restatement, including adjustment; to (i) correctly record inventory receipts in the proper period, (ii )

correct the timing of revenue recognized for a maintenance contract, (iii) correctcommission liability relating to a long-term card product contract, (iv) correctVAT payables and expenses, (v) correct revenue recognized on a milestone basedcontract to match revenue recognized when the milestones were completed, and(vi) correct intercompany allocations which were not properly recorded. While theamounts associated with these other adjustments are relatively small, we believethat it is appropriate to record them as part of this restatement.


S1OLI, STOLs_ BFRNE i .0Y.TThA & SHLACHTER P .C.209 S .W . O/ .K S'T REET

PORTLAND OR-,'C,,)N Q7204T'3L,. (50 .^,) 22`f-1600 FAX(503)227-0840

152 . On April 7, 2005, after almost seven months from the time it revealed its intention

to restate its financial results and after five separately announced delays in its scheduled fi ling

date, Diginiarc finally fi led its Form I 0-K for the year ended 2004 ("FY 04"), and its Form i 0-Q

for the period ended September 30, 2004 ("3Q 04") These filings included restatements of

material amounts of income for every -accounting period in the Class Period as set forth above in

148 .

153 . The Restatement further revealed that the Company used the second quarter o f

2004 negative announcement as an attempt to rid their balance sheet of fraudulent assets

previously reported without admitting they engaged in accounting fraud, as the Company

expensed $836,000 of expenses from prior periods that it had improperly capitalized or retaine d

on its balance sheet. This attempted cover-up of Digimarc's false accounting further

demonstrates Derendants' intention to deceive investors . The Restatement resulted in a net

decrease of $675,000 in the loss reported for the second quarter of 2004, allowing the Company

to report that the net impact of its Restatement was $2 .0 million, although it overstated income by

approximately $2 .7 million during the Class Period .

154 . On June 14, 2005, Digimarc's accountants, KPMG LLP announced that it was

resigning as the Company's independent registered public accounting firm, effective upon th e

filing of the Company's Form I0-Q for the quarter ended June 30, 2005 .

DEFENDANTS' FINANCIAL STATEMENTS DURING THE CLAS S

PERIOD WERE MATERIALLY FALSE AND MISLEADING AND VIOLATED GAAP

155 . At all relevant times during the Class Period, Defendants represented that

Digimarc's financial statements when issued were prepared in conformity with GAAP, which ar e


STOLL S'IiOL,L BERNIS LOKT7NG & SH LACIiTER P .C .200> S. W . OA K STRI.3IrC

PORTLAND. OREGON 972041- EL. (503) 227 .1600 IFAX (503 ) 227-6840

recognized by the accounting profession and the SEC as the uniform rules,. conventions and

procedures necessary to define accepted accounting. practice at a particular time . However, in

order to artificially inflate the price of Digimarc's stock, Defendants used improper accounting

practices in violation of GAAP and SEC reporting requirements to falsely inflate its assets,

stockholders' equity and earnings during the Class Period .

156 . . Digimarc's materially false and misleading financial statements resulted from a

series of deliberate decisions by Defendants designed to conceal the truth regarding Digimarc's

actual operating results . Specifically, as discussed herein, Defendants caused the Company to

violate GAAP by (a) improperly capitalizing costs related to internal use software, (b) improperly

accounting for costs incurred on various projects, (c) failing to timely record a write-down for

slow moving and . obsolete inventory, and (d) failing to establish and maintain an adequate interna l

control system .

157 . As set forth in Financial Accounting Standards Board ("FASB") Statements o f

Financial Accounting Concepts ("CON") No . 1 Objectives of Financial Reporting by Business

Enterprises (November 1 978), one of the fundamental objectives of financial reporting is that it

provide accurate and reliable information concerning an entity's financial performance during the

period being presented. CON No . 1, paragraph 42, states :

Financial reporting should provide information about an enterprise's financialperformance during a period . Investors and creditors often use information aboutthe past to help in assessing the prospects of an enterprise . Thus, althoughinvestment and credit decisions reflect investors' and creditors' expectations aboutfuture enterprise performance, those expectations are commonly based at leastpartly on evaluations of past enterprise performance .


STOLL STOL-L B[RNE LOK -.'cNG & sI ILACUTER P.C .719 S .W . OAK STREET

PORTLAND, OREGON 97204TEL (503) 227-1600 FAX (.503) 227-6840

158, As set forth in SEC Rule 4-01(a) of SEC Regulation S-X, "[f]inancial statements

filed with the [SEC' which are not prepared in accordance with [GAAP] will be presumed to be

misleading or inaccurate," 17 C .F.R. § 210 .4-01 (a)(1) . Management is responsible for preparing

financial statements that conform with GAAP. As noted by the AICPA professional standards :

[F]inancial statements are management's responsibility . . . . [M]anagement isresponsible for adopting sound accounting policies and for establishing andmaintaining internal control that will, among other things, record, process,summarize, and report transactions (as well as events and conditions) consistentwith management's assertions embodied in the financial statements . The entity'stransactions and the related assets, liabilities and equity are within the directknowledge and control of management . . . . Thus, the fair presentation of financialstatements in conformity with Generally Accepted Accounting Principles is animplicit and integral part of management's responsibility .

A. DIGIMARC'S IMPROPER CAPITALIZATION OFINTERNALLY DEVELOPED SOFTWARE COSTSAND IMPROPER PROJECT ACCOUNTING

159 . GAAP requires that assets be recognized when future economic benefits can b e

i easonably expected based on available evidence or logic . FASB CON No. 6 Elements of

Financial Statements (December 1985) 25 n .28 . Specifically, CON No . 6 defines assets as

"probable future economic benefits obtained or controlled by a particular entity as a result of past

transactions, or events ." Id. at 26. "Probable" is defined as "that which can reasonably b e

expected or believed on the basis of available evidence or logic but is neither certain nor proved ."

Id. at n.18. An essential characteristic of an asset is that "it embodies a probable future benefit .-

that involves a capacity . . . to contribute directly or indirectly to future net cash inflows ." Id. at

26. Uncertainty about the actual future economic benefit of an expenditure may preclud e

recognition of an asset and warrant that it be recognized as an expense or a loss . Id . at 175 .


ST OLL . STOLL BrRNE LOKTING & SHLACUTFR P .C .209 S .W . OAK STREET

PORTLAND, OREGON 97204TEL . (503) 227-! 600 L'AX (503) 227-6840

160 . AICPA's Statement of Position ("SOP") 98-1 Accounting for the Costs o f

Computer Software Developed or Obtained for Internal Use states :

Internal and external costs incurred during the preliminary project stage should beexpensed as they are incurred . Internal and external costs incurred to developinternal-use computer software during the application development stage should becapitalized. Internal and ,external training costs and maintenance costs should beexpensed as incurred . 21-23 .

As discussed above, in ¶ 66, Digimare falsely represented that it followed SOP 98-1 policy of

accounting for internally developed software in its 2003 Form 10-K .

161 . As illustrated in the table below, the impact of the errors in the capitalization o f

internally developed software alone had the effect of entirely eliminating the previously reporte d

net income of at least one quarter as well as reducing the previously reported net income of

$2,055,000 for the restated Class Period quarters to net income of $715,000, or by 65% .

(in thousands )

Quarter/End/Fiscal Year En d

Total 2003

3/31/20036/30/20039/30/2003

12/31/2003

Previously ReportedNet income (loss)$ 29

2871,284

(70)1,530

3/31/2004Total 200 4Total impact ofRestatement

525525

2,055

Effect of SoftwareCapitalizationon Net Income

$ (149)(228)(331)(229)(937)

RestatedNet Income (loss )

$ (120)5 9

953(299)593

(403) 122(403) 122

$ (1,340) $ 715

[62. As illustrated in the table below, the impact of Defendants' deceptive projec t

accounting cost tracking and cost deferrals alone had the effect of entirely eliminating th e

previously r,--ported net income of at least one quarter as well as reducing the previously reporte d


SIOLL STOLL BERNE LOKT1NO & SHLACHTER P .C .

209 S-W . OAK STRUT FPORTLAND, OREGON 97204

TEL. (50S) 22'-3600 FAX(503)227-6840

net income of $2,055,000 for the restated Class Period quarters to net incon-re of $456,000, or by

78% .

(in thousands )

Quarter/End!Fiscal Year En d

3/31/20036/30/20039/30/2003

12/31/2003Total 2003

3/31/2004Total 2004Total impact ofRestatement

Effect of ProjectPreviously Reported Accounting

Net income (loss) on Net Incom e$ 29 $ -

287 (15)1,284 (81)(70) (357)1,530 (453)

525525

2,055

RestatedNet income (loss )$ 29

2721,203(427)1,077

(1,146) (621r(1,146) (621 )

$ (1,599) $ 456

163 . Defendants violated GAAP and its own disclosed policies by improperl y

capitalizing expenses that had no future benefit, thereby inflating assets, stockholders' equity, an d

earnings

B. DICIMARC'S EXCESS, OBSOLETE AND SLOW MOVING INVENTORY

164. GAAP provides that an estimated loss from a loss contingency , such as the write-

down of inventory "shall be accrued by a charge to income," if : (i) information available prior to

issuance of the finan ,ial statements indicated that it is probable that an asset had been impaired o r

a liability had been incurred at the date of the financial statements ; and (ii) the amount of the loss

can be r".sonably estimated . Statement of Financial Accounting Standards ("SFAS") No . 5

Accounting for Contingencies (March 1975) 8 . SFAS No. 5 also requires that financia l

statements disclose contingencies when it is at least reasonably possible (i .e. a greater than sligh t

chance) that a loss may have been incurred . The disclosure shall indicate the nature of the


STOLL STOLL BERME LOKTINO & SI1I,ACHTER P .C .

209 S .W . OAK STREETPORTLAND, OREGON 97204

TEL . (503} 2Z7-1600 PAX(503)227-6840

contingency and shall give an estimate of the possible loss, a range of loss or state that such a n

estimate cannot be made.

165 . The SEC considers the disclosure of loss contingencies to be so important to a n

informed investment decision that it promulgated Regulation S-X, which provides that

disclosures in interim period financial statements may be abbreviated and need not duplicate the

disclosure contained in the most recent audited financial statements, except that, "where material -

contingencies exist, disclosure of such matters shall he provided even though a significant change

since year end may not have occurred ." 17 C.F .R. § 210.10 -0 1 .

166, The Company also violated GAAP by failing to write off excess, obsolete and

slow moving inventory in a timely manner in its interim financial statements, as indicated by

Accounting Principles Board ("APB") No . 28 Interim Financial Reporting (May 1973) :

The amolims of certain costs and expenses are frequently subjected to year-endadjustments even though they can be reasonably approximated at interim dates .To the extent possible such adjustments should be estimated and the estimatedcosts and expenses assigned to interim periods so that the interim periods bear areasonable portion of the anticipated annual amount .

167 . In addition, CON No . 5 Recognition and Measurement in Financial Statements o f

Business Enterprises (December 1984) states, "[a]n expense or loss is recognized if it becomes

evident that previously recognized future economic benefits of an asset have been reduced o r

eliminated . . . "

168 . As detailed above in ¶(1; 43, 57-61 ., Digimarc failed to properly account for obsolete

inventory. Furthermore, Digimarc recorded a $726,000 provision for obsolete inventory during

2004 of which $525,000 or over 65% of the reserve was used in 2004 based on Digimarc's

estimate of a future decline in demand of its products . Defendants were well aware of the decline



STOLL STOLL BET NE LOICT1NG & S1ILACHITER P.C.209 S .W . OAK STREET

PORTLAND . OREGON 97204TEL. (503) 1, 27-1 600 FAX (503) 227-6840

in demand throughout the Class Period but continued to carry the inventory on its financia l

statements at inflated amounts . As a result, inventory, gross margins and net income were

materially overstated during the Class Period .

C. DIGIMARC'S FALSE AND MISLEADING FINANCIALSTATEMENTS WERE MATERIAL

169 . The foregoing violations of GAAP were material . Indeed, as the Company

eventually was forced to admit, these violations including (a) improperly capitalizing costs related

to internal use software, (b) improperly accounting for costs incurred on various projects, (c)

failing to correctly record inventory receipts in the proper period, (d) failing to correctly record-

revenue on a maintenance contract, (e) failing to correctly record commission liability relating to

a long-term card product contract, (#) failing to correctly record VAT payables and expenses, an d

(g) failing to correctly record international tax expenses resulted in the Company restating its

financial statements because those financial statements had not been prepared in conformity with

CG .AAP and SEC accounting requirements when they were issued . As set forth in the Company' s

2004 Form I 0-K issued on April 7, 2005, the Company restated its financial statements for the

year ended December 31 ; 2003 as well as the first two quarters of 2004 .

170. In view of "the potential dilution of public confidence in financial statement s

resulting from restating the financial statements of prior periods," according to GAAP, a

retroactive restatement of financial statements is reserved for material accounting errors tha t

existed at the time the financial statements were prepared . APB Opinion No. 20, Accounting

Changes (July 1971) 18, 27, 34-38 . Since GAAP allows only for correction of errors that ar e

Page 91 - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OF. THE FEDERAL SECURITIES LAW

STOLL S I OLL BEFN[: LOKY'N C & SHLACHTER P .C .209 S . W . OAK S1R EET

PORTLAND, OREOOON 7"120 4

EEL. (50'_) 227-1600 FAX (503) 22'-6840

"material," by restating its financial statements, Digimarc admitted the materiality of the errors i n

its previously issued financial statements for fiscal year 2003 and the first two quarters of 2004 .

171 . The foregoing violations of GAAP were material . SEC Staff Accounting Bulleti n

("SAB") No. 99 Materiality emphasizes the need to assess and take into account the qualitativ e

aspects of materiality, -including,-but not limited to :

a, whether the misstatement arises from a an item capable of precisemeasurement or whether it arises from an estimate, and, if so, the degree ofimprecision inherent in the estimate ;

h, whether the misstatement masks a change in earnings or other trends ;

c. whether the misstatement masks a failure to meet analysts' consensusexpectations for the enterprise ;

d. whether the misstatement changes a Loss into income or vice versa ;

e whether the misstatement concerns a segment or other portion of theregistrant's business that has been identified as playing a significant role inthe registrant's operations or profitability ; and

f whether the misstatement has the effect of increasing management'scompensation - for example, by satisfying requirements for the award ofbon uses or other forms of incentive compensation .

172 . The cumulative net impact of the Restatement on Digimarc's previously reporte d

operating results for fiscal year ended December 31, 2003 through the first quarter of 2004 was as

follows:

fin thousands) Previously Reported As Restated $ Change

Cost of Sa=es $59,997 $61,780 $1,783

Net Income (Loss) $2,055 $611 $(2,666 )

Page 92 - , SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LA W

STOLL STILL BERNE LOPTING & S11LACHTER P .C .209 S .W . OAK STRLE T .

PORTLAND, OREGON 97204ML(503)227-1600 FAX (503) 227-6840

173 . In addition to the accounting improprieties stated above, Digimare presented it s

financial statements during the Class Period in a manner which also violated at least the following

provisions of GAAP :

(1) , financial reporting should provide information that is useful to present andpotential investors and creditors and other users in making rational investment,credit and similar decisions (Concepts Statement ("CON") No . 1,11 34) ;

(2) financial repo rt ing should provide information about the economicresources of an enterprise, the claims to those resources , and the effects oftransactions , events and circumstances that change resources and claims to thos e

resources (CON No. 11140) ;

(3) financial reporting should provide information about how management ofan enterprise has discharged its stewardship responsibility to owners(stockholders) for the use of enterprise resources entrusted to it . To the extent thatmanagement offer$ securities of the enterprise to the public, it voluntarily acceptswider responsibilities for accountability to prospective investors and to the publicin general (CON No. I ¶ 50);

(4) financial reporting should provide information about an enterprise'sfinancial performance during a period . Investors and creditors often useinformation about the past to help in assessing the prospects of an enterprise .

Thus , although investment and credit decisions reflect investors ' expectations

about future enterprise performance , those expectations are commonly based atleast partly on evaluations of past enterprise performance (CON No. 1 ¶ 42) ;

(5) financial reporting should be reliable in that it represents what it purpo rts to

represent . That information should be reliable as well as relevant is a notion that iscentral to accounting (CON No. 2 Qualitative Characteristics of Accountin g

Information (May 1980 ) ¶ 58-59) ;

(6) finahcial reporting should be complete , so that nothing is left out of the --

information . that may be necessary to ensure that it validly represents underlyin g

events and conditions (CON No. 2,1179) ; an d

(7) financial reporting should be conservative and ensure that uncertainties andrisks inherent in business situations are adequately considered . The best way toavoid injury to investors is to try to ensure that what is reported represents what itpurports to represent (CON No . ¶C 2, 95, 9 -7 ) .


STOLL S'CULL..'.ERNE LOK FiNG & SHLACHT :R P .C.

209 S.W . OAK STREETPORTLAND, OREGON 97204

TEL. (503) 227-1600 FAX (503) 227.6040

D. DEFENDANTS' VIOLATIONS OF SEC REGULATION S

174. The Company's Class Period reports on Forms 10 -Q and 10-K filed with the SEC

were also materially false and misleading in that they failed to disclose known trends, demands ,

commitments, events, and uncertainties that were reasonably likely to have a materially advers e

effect on the Company's liquidity, net sales, revenues and income from continuing operations, a s

required by Item 303 of Regulation S-K .

175 . Item. 7 of Form 10-K and Item. 2 of Form 10-Q, MD&A require the issuer to

furnish information required by Item 303 of Regulation S-K [17 C .F.R. 229 .303]. In discussing

results of operations, Item 303 of Regulation S-K requires the registrant to :

Describe any known trends or uncertainties that have had or that the registrantreasonably expects will have a material favorable or unfavorable impact on netsales or revenues or income from continuing operations .

176. The instructions to 303(a) further state : The discussion and analysis shall focus

specifically on material events and uncertainties known to management that would cause reported

financial information not to be necessarily indicative of future operating results .

177 . In addition, the SEC, in its May 18, 1989 Interpretive Release No . 34-26831, ha s

indicated that registrants should employ the following two-step analysis in determining when a

known trend or uncertainty is required to be included in the MD&A disclosure pursuant to Item

303 of Regulation S-K :

A disclosure duty exists where a trend, demand, commitment, event or uncertaintyis both presently known to management and is reasonably likely to have a materialeffect on the registrant's financial condition or results of operations .

178 . Nonetheless, Digimarc 's Class Period Forms 10-K and 10-Q failed to disclose the

Company's improper accounting practices as noted above as well as its internal control system


STOLL STOLL BERNE LOKTING & SI-[LACHTLR P.C .209 S W . OAK STREET

PORTLAND, OREGON 9720 4TEL . (5031 227-1 600 FAX (503) 227-6840

deficiencies, all of which were reasonably likely to have a material adverse effect on Digimarc's

operating results, and the disclosure of such was necessary for a proper understanding and

evaluation of the Company's operating performance and an informed investment decision .

179. Further, the undisclosed adverse information concealed by Defendants during the

Class Period is the type of information which, because of SEC regulations, regulations of the

national stock exchanges and customary business practice ., is expected by investors and securities

analysts to he disclosed and is known by corporate officials and their legal and financial advisors

to be the type of information which is expected to be and must be disclosed.

ADDITIONAL SCIENTER ALLEGATION S

A. INDIVIDUAL DEFENDANTS' CONSCIOUS BEHAVIO R

1480 . The scienter of the Individual Defendants Davis and Ranjit is demonstrated, in

particular by, among others, the following summary of the facts pleaded herein (the summary is

not intended to supersede, replace or otherwise substitute for the facts pleaded throughout this

complaint, including, Inter alia, the facts set forth above in the section entitled "Facts

Undermining Defendants' Class Pehod Representations") :

(I). As alleged in ¶¶'130 and 51, according to CW1 and CW2, senior

management of the Company (including the Controller of Digimarc's ID Systems business unit),

who reported directly to Ranjit, munged inventory data in so-called "Access databases" separate-

from the Company's primary accounting system, writing up the value of the ending inventory to

lower the Company's reported costs of goods' sold and boost its reported income . Furthermore, as

alleged in ¶I 33, according to CW1, the separate Access databases were set up because Defendant

Ranjit was unhappy with numbers being generated by the Great Plains system (Digimarc's newly



STOLL STOLL B RNE LOKT :NG & SHLACI STER P .C.



TE _ . (503) 227-1600 F k X (503) 227-664D

integrated accounting software system)) because the Great Plains system reflected (accurately)

much higher consumption of inventory during the production process, which would have resulted

in lower reported income for the Company . CWl and CW2 have knowledge of these facts given

their job responsibilities and positions within the Company as alleged in ¶¶ 30 and 32, and

because, as alleged in ¶( 30, Ranjit directed that the separate Access databases be created .

(2? As alleged in ¶¶ 49 and 61 . according to CWI, Ranjit caused the Company -

to manipulate inventory reserves by reducing, and in fact eliminating, inventory reserves in order

to inflate the Co ipany's financials . As alleged in ¶ 61, Ranjit also refused to allow the write-

down of obsolete inventory because to do so would have significantly reduced the Company's

reported income and make the Company miss market expectations . CW 1 has knowledge of these

facts because, as alleged in 116 1, CW 1 was told by a former vice-president of Digimarc's ID

System's finance department that Ranjit had directed the elimination of the inventory reserves,

and becalus, , as alleged in ¶ 61, CW I h.:;.mlherseif was also instructed by Ranjit not to write down

obsolete inventory becaL se the reserves had been eliminated and if the inventory was written

down the Company would miss market expectations .

(3) Defendant Ranjit was fully aware of Digimarc's improper manipulations o f

reported inventory and costs of good'sold because, as alleged in ¶ 51, according to CW1, on a

monthly basis con-ect inventory and scrap rate was gathered by CW1 and those under his

supervision and emailed to Indra Paul . CW6, Val Ford, and Ranjit . On several occasions, in

response to oiie of CW1's inventory report emails, Ranjit would contact himlher directly by

telephone to talk about the inventory numbers . CWI has knowledge of these facts because, a s


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alleged in T 51, CW1 personally emailed the inventory and scrap rate information to Ranjit and

other senior management, and was personally contacted by Ranjit regarding the information .

(4) As alleged in 1(1152-53, according to CWl, beginning in January 2004,

CW I attended monthly meetings held at Digimarc's Fort Wayne, Indiana, facilities with senior

management during which issues of inventory controls and valuation were discussed . As alleged

in 1148, CW6 also attended some of these meetings . CW6 confirmed that Ranjit attended these

meetings and had to know about the manipulation of Digimarc's reported inventory value .

Defendant Ranjit attended roughly half of these meetings by telephone or in person. On one

occasion in particular, in or about April or May 2004, CW I was present at a meeting in Fort

Wayne, Indiana, in which the issues of inventory, inventory valuation, and the use of the Great

Plains accounting system versus using separate databases to account for the inventory were

discussed . The meeting lasted about an hour, and also in attendance were Paul Gifford, Val Ford,

CW6, and Defendant Ranjit . CWI spent time explaining to the group how Great Plains worked,

and why the inventory numbers input into that system were accurate . In addition to this meeting,

on a separate occasion CWl had a telephone call (in the presence of Ranjit and Rahoul Banerjea)

with a consultant from Microsoft regarding the Great Plains system . This call took place at the

desk of CW2 . During the call, CW I and the Microsoft consultant walked through the process o f

how the inventory numbers were created in the Great Plains system and confirmed that the

numbers were correct . Despite the above-described presentation, and despite the conversation

with the Microsoft consultant, Ranjit and others asserted that they did not believe the numbers

being generated in the Great Plains system. CW I stated that the numbers generated in Great

Plains showed (accurately) a lower value for inventory and a correspondingly higher cost of



STOLL STOLL BERN F. LOKTING & SIILACHTEiR P .C.209 S.W. OAK STREE T


goods sold than Digimarc's financial statements . Ranjit and other members of senior

management who expressed disbelief in the inventory numbers did not state the basis for their

asserted belief. In fact, according to CW1, the IT Department (through the Great Plains system

that it set up and into which the correct inventory data was input) was the ultimate source of the

correct inventory information, and there was no other reliable source from which Ranjit or anyone

else could have obtained accurate inventory numbers . Nonetheless, the Company continued to

make use of the separate Access databases (which, unlike the Great Plains system, had no

controls) to generate the inventory figures used for the Company's financial statements . In fact ,

according to CW 1, the Company never closed its books through the Great Plains system, bu t

instead used the numerous Access databases created outside the Great Plains system . At the end

of the quarter, CWI~ and those under his/her supervision took these numerous databases and rolled

them into one single database which was then given to Val ford for use in preparing the

Company's financials . According to CWi, this enabled Defendants to manipulate the Company's

reported inventory and falsely boost the Company's reported income . CW 1 has knowledge of

these facts because, as alleged in 1130, during the Class Period CW 1. was first Director of the IT

Department of Digimarc's ID Systems business unit, and then the Director of Supply Chain

Management at Digimarc. CW1 also has knowledge of these facts because, as alleged in ¶j 52-

53, helshe was personally present at the monthly meetings with Ranjit and other senior

management where the above-described discussions occurred, was a party to the conversation

described above that took place with the Microsoft consultant, and was responsible at quarter's

en,d for rolling the various Access databases into a single database that CWI then gave to Val

Ford for use in preparing the Company's financials .

Page 98 - SECOND AMENDED CLASS ACTIN COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LA W

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(5) As alleged in 11 54, at the meeting in Fort Wayne, Indiana described above ,

CWI also explained to Ranjit and other members of senior management that the Company's

actual scrap rates were much higher than the Company's assumed scrap rates and this was why it

appeared as if inventory was disappearing . CW 1 explained that the balance sheet was not being

relieved of inventory consumed in production, and thus the costs-of-goods-sold expense charged

against earnings was too low. CW1 has knowledge of these facts because, as alleged in ¶ 52,

he/she personally attended the meeting in port Wayne and also performed work to calculate what

the actual scrap rates were in preparation for this meeting .

(6) As alleged in 1155, according to CW3, senior management at the Compan y

(Nvho were directed by Ranjit) instructed the ID Systems staff accountant to improperly boo k

certain purchases of materials used in the service or maintenance of existing drivers licens e

programs so that the purchase expenses could be capitalized and would riot lower the Company' s

reported earnings . CW3 has knowledge of these facts because, as alleged in ¶ 55 . the staff

accountant told these facts to CW3 .

(7) As alleged in ¶jqj 58-59, according to CWI, between April and June 2004 ,

CW1 had a number'of discussions with senior executives, including Defendant Ranjit, Rahou l

Banerjea, Val Ford, and Indra Paul, to discuss the serious problems Digimarc had with

overvalued and obsolete inventory on its books . CW1 also informed senior managemen t

(including Paul, who reported to Ranjit) of these serious problems by way of wri tten report

(which report had been prepared at the direction of Paul) . Senior management responded that

they were concerned enough already about making "our numbers ," had no inventory reserves

remaining, and lodl ed to find a way to wait until a later quarter to disclose the long obsolete


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inventory numbers . According to CW1, a project accountant for the Company, who had bee n

employed by Polaroid when the ID Systems business unit was purchased in late 2001, specifically

told Ranjit in December 2001 about the cameras in inventory at the time that were alread y

obsolete, the total value of which at the time was roughly $240,000 . These obsolete cameras

were part of the $2 million or so in obsolete inventory about which CW 1 informed senio r

management in the above-described report . CW I has knowledge of these facts because, a s

alleged in 1,11 ; 58-59, CWI reviewed inventory reports that showed the inventory remained there

for several years, CW 1 him/herself prepared the written report to senior management regardin g

the problem. and was him/herself informed by senior management of its position regarding th e

reporting of the obsolete inventory in the Company 's financial statements , and because CWl wa s

told b~~ the project accountant described above about the conversation the project accountant ha d

with Ranjit in December 2001 .

(8) As alleged in ¶ 67, according to CW2, the Controller of Digimarc's I D

Systems business unit, who repo rted directly to Ranjit, instructed CW2 to el iminate internal

control processes intended to prevent the improper capitalization of software development relate d

payroll expenses . CW2 has knowledge of these facts because, as alleged in ¶ 67, CW2

him/herself was instructed by the Controller to eliminate the internal control processes .

According to CW ., Ranjit had specific knowledge of the elimination of these internal contro l

processes . C 'n'1 has knowledge of this fact because, as alleged in ¶( 68, when CW2 was firs t

instructed to eliminate these accounting controls, CW2 contacted CW 1 who in turn approache d

Val Ford. Ford told CWI that Ranjit had ordered the controls removed. According to CW 1 ,

he/she then sent an email to Ranjit about the elimination of controls in the capitalization o f


STOLL STOL L BORNE E,OK"IThO & SHLACHTER P .C .209 S W . OAK S FRFF T

PORTLAND, OREGON 97204

7'EL . (5031227-1600 FAX ,503) 227-6840

software payroll, and Ranjit responded that was what he wanted and that he expected CW1 to

take care of it . .

(9) As alleged in ¶ 71, according to CW1, at the close of the first quarter of

2003, Ranjit ordered an ID Systems controller to make last minute journal entries that improperly

increased the amount of software development-related payroll that was capitalized . Later, CW I

learned from Martin Day, then Digimarc's Controller, that the Company had made some of

entries despite Susan Scaechi's objections . CWl has knowledge of these facts because, as

alleged in 117 1, the ID Systems controller told these facts to CW1 .

(10) As alleged in 1 86, 95, 101, 115, 122, and 124, in connection with each of

the false quarterly reports to the SEC, Ranjit and Davis, pursuant to § 302 of Sarbanes-Oxley,

each attested that internal control procedures were in place and functioning, that each had

reviewed Digimarc' SEC filings, and that, based on their knowledge, none of the information

presented in those report; was false or misleading . In addition, and also as alleged in ¶¶ 86, 95,

101, 115, 122, and 124, Ranjit and Datiis certified that they were each responsible for establishing

and maintaining I)igimarc's disclosure controls and procedures, and that : (a) they had designed

controls and procedures to ensure that material information "is made known to us by others"

within Digimarc during the period covered by the report; (b) they had personally evaluated th e

effectiveness of those controls within the last 90 days ; and (c) any deficiencies in those controls

and procedures had been disclosed in the 10- •Q repo rt , as well as to Digimarc 's outside auditors

and internal audit commi ttee. Davis and Ranjit's Sarbanes - Oxley certifications conclusively

establish their knowledge; of the state of internal control procedures at Digimarc and show their

scienter in causing Digimarc to make materially false statements in its SEC filings .

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STOLL STOLL BERNE LOKTING & SHLACHTER P .C .209 S.W. OAK STREET

PORTLAND, OREGON 9720 4TEL . (503) 227-1600 SAX (503) 227-6840

B. INSIDER TRADING

181 . As discussed above, Defendants Davis and Ranjit each gained personally fro m

their, deception of the investing public because they sold significant amounts of Digimarc stock a t

artificially inflated prices during the Class Period as set forth in the following tables :

Bruce Davis DATE SHARES PRICE PROCEED S

1 l!03/2003 19,000 $17 .00 $323,000 .0 0

10/31/2003 1,000 $17 .00 $ 17,000 .0 0

6/02/2003 18,750 514.42 $270,375 .0 0

TOTAL : 38,750 $610,375 .0 0

E . K. Ranj t DATE SHARES PRICE PROCEEDS

5/04/2004 10,000 $11 .00 $110,000 .0 0

6;03/2003 10,000 $14-80 $148,000 .0 0

5/2912003 4,000 $14.50 $ 5000 .0 0

5/28/2003 1,000 $14 .50 $ 14,500 .0 0

5/23'2003 5,000 $14 .45 $ 72,250 .0 0

TOTAL : 30,000 $392,750 .0 0

182. As highlighted in the chart above, Defendants sold Digimarc stock in unusua l

amounts and of suspect tinning . In fact, the proceeds from these sales were 150% of Davis' salar y

and bonus for 2003, and almost double Ranjit's 2003 salary . Defendants Davis and Ranji t

unloaded 4 '/2%, and over 48%, respectively, of their total personal Digimarc stock holdings ,

including options, at artificially inflated prices . 5

These percentages of their holdings (which include all of their stock options) may bematerially higher since it appears that many of the stock options were "out of the money" at thetime and, therefore, could not be converted easily to shares and sold immediately . For example,according to the Schedule 14A that the Company filed with the SEC on April 1, 2004, themajority of Davis' holdings are stock options granted to him by the Company . Davis' holdings


STOLL STOLL BERNS LOKTING & SI ILACHTER P .C .209 S.W. OAK STREE T


183 . As set forth in the table above, both Davis and Ranjit sold large blocks of stock in

late May and early June 2003, only weeks after Digimarc began using accounting manipulations

to meet the market's earnings expectations for the Company and after Davis and Ranjit ha d

certified in Digimare's Form 10-Q filing for 2Q 03 that they had participated in and supervised

the evaluation of the effectiveness of the Company's disclosure controls and procedures and an y

changes that occurred in Digirnarc's internal controls over financial reporting fhn that fiscal

period. Davis sold another large block of stock during 4Q 03, when Davis and the Company

knew its revenue and earnings forecasts for this quarter were unreasonably high and that revenues

for this quarter were going to decline based on the seasonality of drivers license issuances, which

was well known within the Company . Ranjit sold another large block of stock on May 4, 2004,

five days after Digimarc reported its financial results for IQ 04, which results overstated income

by more than $1 .3 million, turning what was really a loss of $785,000 into reported income of

$525,000 .

C. ENTRENCHMENT

184 . The Individual Defendants were motivated to inflate Digimarc's financial results

during the Class Period to protect their positions with the Company, as well as improve their

opportunities for advancement and increased compensation . As alleged above, Defendants issued,

false and misleading statements regarding Digimnarc's future revenues and earning growth, and -

included, ats of Dec :,mber 31, 2003, 688,111 exercisable stock options and 285,952 unexercisable

options . The value of Davis' exercisable options that were "in the money," or had a stock priceabove the market price of Digimarc ' s stock, had a cash value of only $365 ,538. Thus, as ofDecember 31, 2003, the majority of Davis' options were "out of the money" or had a stock pricethat was higher than the market price of Digimarc stock and, therefore , not convertible into cash .


STOLL- STOLL BERNE. LOKCING & SlILACHTGR P .C .209 S .W. OAK STREET

PORTLAND, ORLUON 97204TEL-!5O3) 227.1600 FAX (503) 227-6840

repeatedly adjusted the forecasts so the market would perceive the Company as growing an d

successful . Defendants were motivated to falsify the Company's financial results to meet th e

false expectations they created .

185. Defendant Davis had motive to inflate Digimarc's reported financial performanc e

because he knew that during the Class Period, the Company was evaluating his compensation

package, and it cartainly would depend in large part on Digimarc's reported financia l

performance. Ultimately, Davis' bonus was based in part on Diginlarc's "operating profit . "

Based on the false financial results reported in 2003, Davis received a bonus of $113,000 .

186. Based on the inflated financial results, both Davis and Ranjit were also rewarde d

with stock option grants. On January 2, 2004, the Company granted Davis I 10,000 stock options .

On that same day, Ranji~t received a grant of 25,000 stock options, doubling the amount of share s

he beneficially owned.

i 87 . By contrast, there was rapid turnover in Digimarc's ID Systems financia l

department, as a series of controllers left the Company . Susan Scacchi, who was controller o f

Digimarc for only a few months, left the Company early in the Class Period . According to CW1 ,

he/she learned from Scacchi that she left because Ranjit and Paul Gifford had asked her to mak e

improper last minute entries in the close of the quarter, including improper capitalization of

payroll . CW6 corroborated that Scacchi left Digimarc because . she believed that senior

management was unethical . Also according to CW3, another former controller, Diana King, left

the Company in late 2003 because she objected to the lack of accounting and internal controls .

According to both CW 1 and CW2, they left the Company because of the serious accounting

problems and internal control issues they observed .


STOLL STOLE BERNE LOKTU G & SHLACHTEER P .C .209 S W . OAK STREET

POR FLAND, OREGON 97204FL l , (99 3)22 -1000 MY(503)227-6840

D. RAISING CAPITAL THROUGH A PRIVATE PLACEMENT OFFERING

188. Dur=ng the Class Period, Defendants were motivated to inflate the price o f

Digimarc stock so .that the Company could complete a lucrative private placement . On August

25 7 2003, Digimare completed a private placement offering whereby it sold 1,785,996 units to

institutional and accredited investors, raising net proceeds of $23 .5 million for Digimarc . The

units were priced at $14 each, and included one share of stock and a warrant to purchase 0 .15 of a-

share of common stock at an exercise price of $14 per share . As part of the transaction, the

Company agreed to file a registration statement for the common stock to be sold in the private

placement, and the warrants were exercisable until 15 days after the effectiveness of the

registration statement . On December 23, 2003, the Company announced that it intended to use

the proceeds "to fund future acquisitions and other market development activities, and for general

corporate purposes ." On January 21, 2004, the Company announced that all of the warrants issued

in the private placement had been exercised at the inflated price of $14 per share . Thus, by

artificially maintaining the price of Digimarc's stock, the Company was able to raise over

$27,250,000 to fund its ongoing operations .

E. CORPORATE SCIENTE R

189. All of the above allegations, in addition to demonstrating the scienter of the

Individual Defendants Davis and Ranjit, also demonstrate the scienter of the Company (given

Davis's and Ranjit's positions within the Company and that they were acting at all times as agents

of Digimarc) . The Company is a named Defendant herein, in addition to the Individual

Defendants, and is independently responsible for the actions taken on its behalf .


STOLL SFOL? . BERNE C .DR .'!N(i & SHLACHTER P .C .409 S.W . OAK STREET

PORTLAND. OREGON 97204Tr-!-, (503) 227-1600 PAX (503) 227-6840

190. The scienter of the Company is further shown by the following summary of the

additional facts pleaded herein (the summary is not intended to supersede, replace or otherwise

substitute for the facts pleaded throughout this complaint, including, inter alia, the facts set forth

above in the section entitled "Facts Undermining Defendants' Class Period Representations") :

(1) As alleged in ¶jJ 6, 9, 17, 59-61, 158 and 159, the Company repeatedly

violated several GAAP provisions by failing to write off obsolete and missing inventory, even

while tracking it in a separate account and after discovering that the inventory was missing or had

been destroyed as obsolete .

(2) As alleged in ¶jJ 146-148, the Company deliberately chose to improperly

capitalize, rather than expense, millions of dollars of ordinary expenses .

(3) As alleged in ¶ 46, during the spring of 2044, CW 1 met with Rahoul

Banerjea (Digimarc's former ID Systems Vice-President of Finance) and a consultant for the

Great Plains system, regarding the proper scrap rate that needed to be used in order to accurately

reflect inventory . CWI informed Banei.jea during this meeting that the Company had a problem

with "seriously overvalued inventory" and that the Company was not accounting for scrap

properly. According to CW1, senior management at Digimarc (including Val Ford and Ranjit)

applied an across-the-board scrap rate of anywhere between 5%-30% (which was included in the

inventory reserve account), even though CW1 explained to Banez jea during this meeting that the

scrap rates were often as high as 60%. After the meeting with Banerjea , CW1 had a conversation

with senior management ( including Ranjit, Indra Paul, Paul Gifford , and the then Controller of

Digimare and the ID Systems business unit ) about the problems, and sent senior management an

email detailing the inventory problems, including the fact that the scrap rates should be applied at



STOLL STOLL BERNE LOKTING & SHLACI ITER P .C .209 S .W OAK STREET


each stage of the manufacturing process and not only to the end product . CW1 has knowledge of

these facts given his/her job responsibilities and position within the Company as alleged in ¶ 30,

and because , as alleged in ¶ 46, CW1 and those under his/her supervision had calculated the

correct scrap rates, CW 1 him/herself was present at the meeting with Banerjea described above,

and CW1 him/hers.-If had the above -described conversation with , and sent the above-described

email to senior management .

(4) As alleged in 1156, the Company admitted in the Restatement of it s

financial results that it improperly capitalized approximately $627,000 of research and

development expenses in 2003, contrary to GAAP and the Company's publicly disclosed

accounting policy .

(5) As alleged in ¶ .57, according to CW3, the Company's senior managemen t

instructed the ID Systems staff accountant to capitalize research and development purchases and

expenses, but instructed the staff accountant to begin amortizing those purchases and expenses

only when the asset;, had become revenue generating. The staff accountant was never instructed

to close out projects with capitalized expenses and therefore the research and developmen t

expenses tliat were being capitalized were. improperly accumulating on the Company's balance

sheet. CWT has knowledge of these facts because, as alleged in ¶ 57, the ID Systems staf f

accountant told these facts to CW3 .

(6) As alleged in ¶ 69, according to CW3, the President of Digimarc's ID

Systems business unit instructed employees to assign more payroll time to particular projects in

order to capitalize; those expenses, even if the employees' time was not spent on those particula r


STOLL ST<)Lt . BERN U. [.,OKTING & SHI,ACHTIER P .C .

209 S .W . OAK SJ'REE r

PORTLA=.v0, OREGON 9720 4TEL . (503) 227-1600 1--26X(1503)227-6840

projects that were appropriate for capitalization . CW3 has knowledge of these facts because, as

alleged in ¶¶ 69, a Digimarc financial analyst told these facts to CW3 .

(7) As alleged in ~ 72, the Company admitted in the Restatement of its

financial results that it violated AICPA SOP 98-1 and Digimarc's publicly-disclosed accounting

policy, and improperly capitalized material amounts of ordinary expenses as software

development costs .

(8 ) As alleged in ¶T, 72-74. the Company has admitted in the Restatement of its

financial results that it lacked documentary support for capitalization of certain software

development costs, that it had an inadequate system for tracking costs that purportedly qualified

for capitalization, and had inadequate "detective controls" to determine whether costs that were

being capitalized as software development costs qualified for capitalization . The Company

further admitted that it capitalized certain expenses as software development costs that were

incurred For a nonsoftware project .

(9) As alleged in ¶T[ 78-79, according to CW3, the President of Digimarc's ID

Systems business unit, at the direction of Digimarc's corporate office in Tualatin . Oregon,

changed the internal forecasts prepared by a Digimare financial analyst by adding revenues where

there was no basis 5_o expect revenue beyond the financial analyst's forecast, and by reducing the

forecasts for expenses without any reasonable basis for doing so. CW3 has knowledge of these

facts because, as alleged in ¶¶ 78-79, the financial analyst whose forecasts were changed told

these facts to CW3 .

(10) As alleged above in ¶ 48, according to CW6, Rahoul Barierjea (Digimarc's

former ID Systems V ice President of Finance) was manipulating inventory accounts to make it

Page 108 - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION O FTHE FEDERAL SECURITIES LA W

STOLL STOLL BERNG L.OKTINC & SI1LACI1TER P,C .209 S .W . OAK Si RM" T

PORTLAND, OREGON 97204TEL . (503) 227-1600 FAX(503)227-6840

appear that the Company had inventory it did not have . CW6 was involved in several meetings

involving senior management where the Company's inventory accounting problems were

discussed .

INAPPLICABILITY OF THE STATUTORY SAFE HARBO R

191 . The federal 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 . None of the false statements regarding Digimarc's purported actual financial result s

pleaded herein were "forward-looking statements" when made . Nor was it stated that actual

results "could differ materially from those projected ." The clear language of the Private

Securities Litigation Reform Act expressly excludes from the safe harbor protection statements

that are "included in a financial statement prepared in accordance with generally accepted

accounting principles ." 15 U.S.C. § 78u-5(b)(2){A.) .

192 . With respect to Defendants false and misleading forward-looking statement s

pleaded above, Defendants are liable for these materially false and misleading statements because

at the time each of those forward-looking statements was made, the speaker knew the forward-

looking statement was false or misleading and the forward-looking statement was authorized

and/or approved by an executive officer of Digimarc who knew that those statements were fals e

or misleading when made .

GROUP PLEADING AND CONTROL PERSON ALLEGATION S

193 . As discussed above, and corroborated by CW1, Ranjit required Digimarc's

financial data to be pulled out of Digimare's accounting system and placed into spreadsheets prior

to the close of the quarter, purportedly so senior management could analyze the data. According



STOLL STOI..i.. BERN G LOKTIN( & SHLACHTER P .C.

209 S.W. OAK STREE T

PORTLAND, OREGON 97204TEL . (50"i) 221-i600 FAX(503)227-6840

to CW I, the purpose of this was to allow for adjustments as needed to meet analysts' expectations

for the Company . The Company has now admitted that improper accounting practices materially

boosted the Company's reported income for each and every quarter during the Class Period .

194. Also as discussed above, according to CW3, senior management would make

unsupported and unreasonable adjustments to the internal budgets that were put together by

finance personnel in charge of forecasting. According to CW3, senior management's adjustment s

were malicious, and were done to create a false impression that the Company was growing it s

revenues and profits at unsustainable rates .

195 . The Individual Defendants were high-level executives at the Company during the

Class Period and members of the Company's management team or had control thereof . Each of

these Defendants, by virtue of his responsibilities and activities as a senior officer of the

Company was privy to and participated in the creation, development and reporting of the

Company's internal budgets, plans, projections and/or reports . Each of these Defendants enjoyed

significant personal contact and familiarity with the other Defendants and was advised of and had

access to other members of the Company's management team, internal reports and other data and

information about the Company's finances, operations, and sales at all relevant times . Each of

these Defendants was aware of the Company's dissemination of information to the investin g

public which they knew or recklessly disregarded was materially false and misleading .

196. It is appropriate to treat the Individua! Defendants as a group for pleading purposes

and to presume that the false, misleading and incomplete information conveyed in the Company's

public filings, press releases and other publications as alleged herein are the collective actions of

the narrowly defined group of Defendants identified above. Each of the above officers o f


STOI L. STOLL FrRNC' LOKTLN(i & SI IL,ACP[TER P .C.

209 S.W. OAK SIREE T°ORTLAND, OREGON 97204

TEL : {563) 227-1600 FA.X {503) 227-6840

Digimarc, by virtue of their high-level positions with the Company, directly participated in the

management of the Company, was directly involved in the day-to-day operations of the Company

at the highest levels and was privy to confidential proprietary information concerning the

Company and its business, operations, products, growth, financial statements, and financial

conditions, as alleged herein . Said Defendants were involved in drafting, producing, reviewing

and/or disseminating the false and misleading statements and information alleged herein, were

aware:, or recklessly disregarded, that the false and misleading statements were being issue d

regarding the Company, and approved or ratified these statements, in violation of the federal

securities laws .

197. As officers and controlling persons of a publicly held company whose common

stock was, and is, registered with the SEC pursuant to the Exchange Act, traded on the NASDAQ,

and governed by the provisions of the federal securities laws, the Individual Defendants each had

a duty to promptly disseminate accurate and truthful information with respect to the Company's

financial condition and performance, growth, operations, financial statements, business, products,

markets, management, earnings, and present and future business prospects, and to correct any

previously issued statements that had become materially misleading or untrue, so that the market

price of the Company's publicly traded common stock would be based upon truthful and accurate .

information . The Individual Defendants ' misrepresentations and omissions during the Class

Period violated these spec ific requirements and obligations .

198 . The Individual Defendants participated in the drafting , preparation and/or approval

of the various press releases, shareholder reports, SEC flings, and other communications

complained of herein and were aware of, or recklessly disregarded, the misstatements contained

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STOLL STO1 .1 B ERNF LOK : NG & SI+I,ACHT E R P .C .


PORTLAND, ORF..GON 97204FPt_ . (503) 227-1600 FAX (503) 227-6840

therein and omissions there from, and were aware of their materially false and misleading nature .

Because of their executive and managerial positions with Digimarc, each of the Individual

Defendants had access to the adverse undisclosed information about Digimare's business ,

prospects, and financial condition as particularized herein and knew (or recklessly disregarded )

that the se adverse facts rendered the positive representations made by or about Digimarc and it s

business issued or adopted by the Company materially false and misleading .

199 . Digimarc and each of the Individual Defendants are liable as participants in a

fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of

Digiraare's common stock by disseminating materially false and misleading statements and/or

concealing material adverse facts . The scheme deceived the investing public regarding

Digimarc's business, ope;•rations, management and the intrinsic value of Digimarc's commo n

stock .

CLASS ACTION ALLEGATION S

200 . Plaintiffs bring this action as a class action pursuant to Rule 23 (a) and (b)(3) of the

Federal Rules of Civil Procedure on behalf of a class consisting of all persons who purchased the

publicly traded securities of Digimarc between April 22, 2003, and July 28, 2004, inclusive (th e

"Class'-"? . Excluded from the Class are the Defendants herein, members of each Individua l

Defendant's. immediate fam;ly, any entity in which any Defendant ' as a controlling interest, and-

the legal affiliates, representatives, heirs, controlling persons, successors, and predecessors i n

interest. or assigns of any such excluded party .

201 . Because Digimarc has millions of shares of common stock outstanding, an d

because the Company 's common stock was actively traded on the NASDAQ under the symbol


STOLL STOLL BERNE LOKT[NG & SHL .ACE-LTER P.C .209 S .W . OAK STREET

PORTLAND, ORES"SON 97204TE (3,-u3)2271600 P.AX (503) 227-6540

"DMRC" throughout the Class Period, members of the Class are so numerous that joinder of all

members is impracticable . While the exact number of Class members is unknown at this time and

can only be determined by appropriate discovery, Plaintiffs believes that Class members number

at least in the thousands and that they are geographically dispersed .

201 Plaintiffs' claims are typical of the claims of the members of the Class, because

Plaintiffs and all of the Class members sustained damages arising out of Defendants' wrongful

conduct complained of herein .

203 . Plaintiffs will fairly and adequately protect the interests of the Class members and

has retained counsel who are experienced and competent in class and securities litigation .

Plaintiffs have no -interests that are contrary to or in conflict with the other members of the Class

Plaintiffs seeks to represent.

204 . A cla s action is superior to all other available methods for the fair and efficien t

adjudication of this controversy, since joinder of all members is impracticable . Furthermore, as

the damages suffered by individual members of the Class may be relatively small, the expense

and burden of individual litigation mattes it impossible for the members of the Class individually

to redress the wrongs suffered . There will be no difficulty in the management of this action as a

class action .

205 . Questions of law and fact common to the members of the Class predominate over

any questions that may affect only individual members in that Defendants have acted on grounds

generally applicable to the entire Class . Among the questions of law and fact common to the

Class are :

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STc LL STOU BERNE L .OKTING & SHLACHTCR P .C .2093 W . OAK STREET

PORTLAND. OR-CON 972.041T-!,.(503)227-1600 I'AX (503) 227-6840

(a) whether the federal securities laws were violated by Defendants' acts as

alleged herein ;

(b) whether the Company's publicly disseminated releases and statement s

during the Class Period omitted and/or misrepresented material facts and whether Defendant s

breached any duty to convey material facts or to correct material facts previously disseminated ;

(c) whether Defendants participated in. and pursued the fraudulent scheme o r

course of business complained of;

(d) whether Defendants acted willfully, with knowledge or recklessly, i n

omitting and/or misrepresenting material facts ;

(e) whether the market prices of Digimarc common stock during the Clas s

Period were artificially inflated due to the material nondisclosures and/or misrepresentation s

complained of herein ; and

(f) whether the members of the Class have sustained damages and, if so, what

is the appropriate measure of damages .

APPLICABILITY OF PRESUMPTION OF RELIANCE :FRAUD-ON -THE-MARKET DOCTRIN E

206. Plaintiffs will rely, in part, upon the presumption of reliance established by th e

fraud-on-the-market doctrine in that, among other things :

(a) Defendants made public misrepresentations or failed to disclose facts

during the Class Period ;

(b) the omissions and misrepresentations were material ;

(c) Digimarc securities traded in an efficient market ;

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STOLL STOLL BERNE € OKTING & SHLACHTER P.C .209 S W . OAK STREET

PORTLAND, OREGON 97204TU,1. . (503) 227-1600 FAX(503)227-6940

(d) the misrepresentations alleged would tend to induce a reasonable investo r

to misjudge the value of the Company's securities; and

(e) Plaintiffs and the other members of the Class purchased Digimar c

securities between the time Defendants misrepresented or failed to disclose material facts and th e

time the true facts were disclosed, without knowledge of the misrepresented or omitted facts .

207. At all relevant times, the market for Digimare securities was an efficient marke t

for the following reasons, among others :

(a) Digimarc securities were listed and actively traded during the Class Perio d

on the NASDAQ, an open, highly efficient and automated market ;

(b) as a regulated issuer, Digimarc regularly made public filings, including it s

Forms 10-K, Forms l0-Q and related press releases, with the SEC ;

(c) Digimarc was followed by analysts from major brokerages including :

Janney Montgomery Scott, LLP ; D.A . Davidson & Co . ; PacificCrest ; Raymond James & Assoc . :

Morgan Keegan & Co .; ,and SG Cowen ;

(d) the reports of these analysts were redistributed to the brokerages' sale s

force, their customers, and the public at large ; and

(e) Digirnare regularly communicated with public investors via established

marke-f communication mechanisms, including the Company's website, regular disseminations o f

press re-l.eeases on the major news wire services, and other wide-ranging public disclosures, such a s

communications with the financial press, and other similar reporting services .

208. As a rti sult, the market for Digimarc securities digested current information

regarding the Company from the publicly available sources described above and reflected suc h

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STOLL STOL L BERN t. LOKI'M & SHLAC[ IT R P .C .209 S .W . OAK STREE T

PORTLAND, OR LOGN 9720 4TEL . (503 ) 227-1600 PAN ,;S03) 227-6340

information in the prices of Digimarc's securities . As would be expected where a security is

traded in an efficient market, material news concerning Digirarc's business had an immediate

effect on the market price of Digimare's securities, as evidenced by the rapid decline in the

market price in the immediate aftermath of Digimare's corrective disclosures as described herein .

tender these circumstances, all purchasers of Digimarc's securities during the Class Period

suffered similar injury due to the fact that the price, of Digimarc securities was artificially inflated .

throughout the Ciass Period and the artificial inflation was released therefrom on January 20,

2004 and July 28, 2004 . At the times they purchased or otherwise acquired Digimare's securities ,

Plaintiffs and other members of the Class were without knowledge of the facts concerning the

wrongful. conduct alleged herein and could not reasonably have discovered those facts . As a

result, the presumption ofreliance applies . Plaintiffs will also rely, in part, upon the presumption

of reliance established by a material omission .

COUNT I

FOR VIOLATIONS OF SECTION 10(b) OF THE EXCHANGE ACT ANDRULE 10b-5 PROMULGATED THEREUNDER AGAINST ALL DEFENDANTS

209. Plaintiffs repeat the allegations set forth in the above paragraphs as though full y

set forth herein. This claim is asserted against Digimarc and the Individual Defendants .

210. During the Class Period, Defendants, carried out a plan, scheme and course o f

conduct which was intended to, and did : (a) deceive the investing public, including Plaintiffs an d

other Class members, as alleged herein ; (b) artificially inflate and maintain the market price o f

Diginiare securities ; and (c) cause Plaintiffs and other members of the Class to purchase Digimar c

Page 1 I6 - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OF. THE I EDERAL SECURITIES LA W

STOLL STOLE BBERNE LOKTING & SHLACHTrr_R P .C .209 S .W . OAK STREET

PORTLAND, OREGON 97204TE!.(503)227-1600 PAX (503) 227-6840

securities at artificially inflated prices during the Class Period . In furtherance of this unlawful

scheme, plan and course of conduct, Defendants took the actions set forth herein .

211 . Defendants : (a) employed devices, schemes, and artifices to defraud ; (b) made

untrue statements of material fact and/or omitted to state material facts necessary to make the

statements not misleading ; and (c) engaged in acts, practices and a course of business which

operated as a fraud and deceit upon the purchasers of the Company's securities in an effort to

maintain artificially high market prices for Digimarc securities in violation of Section 10(b) of the

Exchange Act and Rule 10b-5 . Defendants are sued as primary participants in the wrongful and

illegal conduct charged herein, and as controlling persons of Digimarc, as alleged below .

212. In addition to the duties of full disclosure imposed on Defendants as a result o f

their affirmative statements and reports, or participation in the making of affirmative statements

and reports to the investing public, they 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. § 210 .01 et seq.) and S-K (17 C .F.R.

§ 229.10 ei seq .) and other SEC regulations, including accurate and truthful information with

respect to the Company's operations, financial condition and performance so that the market

prices of the Company's securities would be based on truthful, complete and accurat e

information .

213 . Defendants , individually and in concert, directly and indirectly, by the use of

means or ins trumentalities of interstate commerce and/or of the mails, engaged and participated in

a continuous course of conduct to conceal adverse material information about the business,

business practices , performance , operations and future prospects of Digimarc as specified herein .


THE FEDERAL SECURITIES LA W

STOLL S 'TOU. BERNE LOKTJN .i & SI ILAC}3T3?[2 P.C .

209 S .W . OAK STRTIL TPORTLAND . ORECON 9720 4

-, E_. L . (50 .) 227- ! 630 !' A> 1503 ) 227-6840

These Defendants employed devices, schemes and artifices to defraud, while in possession of

material, adverse, non-public information and engaged in acts, practices, and a course of conduct

as alleged herein in an effort to assure investors of Digimarc's value and performance and

substantial growth, which included the making of, or the participation in the making of, untrue

statements of material facts and omitting to state material facts necessary in order to make the

statements made about Digimarc and its business, operations and future prospects in the light of

the circumstances under which they were made, not misleading, as set forth more particularly

herein, and engaged in transactions, practices and a course of business which operated as a fraud

and deceit upon the purchasers of Digimarc securities during the Class Period .

214. Individual Defendants' primary liability, and controlling person liability, arise s

from the following facts : (a) Individual Defendants were all high-level executives and/or directors

at the Company during the Class Period ; (b) each of these Defendants, by virtue of his

responsibilities and activities as a senior executive officer and/or director of the Company, was

privy to and participated in the creation, development and reporting of the Company's internal

budgets, plans, pro.iections and/or reports; (c) the Individual Defendants enjoyed significant

personal contact and familiarity with each other and were advised of and had access to other

members of the Company's management team, internal reports, and other data and information

about the Company's financial condition and performance at all relevant times ; and (d) these

Defendants were aware of the Company's dissemination of information to the investing publi c

which they knew or recklessly disregarded was materially false and misleading .

215 . Defendants had actual knowledge of the severe misrepresentations and omissions

of material facts set forth herein , or acted with reckless disregard for the truth in that they failed to


THE FEDERAL SECURITIES LA W

S"COLI STOC.L BERNE t .OK T iNG & SHLACHTER P .C .

209 S .W . OAK STRLR TPORTLAND, OREGON 9720 4

t'EiL . 003) 227 1600 FAX(503)227,6840

ascertain and to disclose such facts, even though such facts were readily available to them. Such

Defendants' material misrepresentations and/or omissions were done knowingly or recklessly and

for the purpose and effect of concealing Digimarc's operating condition, business practices and

future business prospects from the investing public and supporting the artificially inflated price of

its stock. As demonstrated by their overstatements and misstatements of the Company's financial

condition and performance throughout the Class Period, the Individual Defendants, if they did not

have actual knowledge of the misrepresentations and omissions alleged, were deliberatel y

reckless in failing to obtain such knowledge by intentionally refraining from taking those step s

necessary to discover whether those statements were false or misleading .

216, The statements alleged hereinabove that form the basis of the confidentia l

witness's knowledge of the scienter of Defendants are, not hearsay because, at the time the

statements were made, they were made either by Davis or Ranjit themselves, or are attributable to

the Company (who is also a Defendant) because the statements were made by Digimarc's agents

or employees concerning a matter within the scope of the agency or employment, made durin g

the existence of the relationship .

217 . The totality of the allegations herein demonstrate that Defendants acted wit h

sclen er .

218 . As a'result of the dissemination of the materially false and misleading informatio n

and failure to disclose material facts, as set forth above, the market price of Digirnarc's commo n

stock was artificially inflated during the Class Period . Unaware of the fact that the market pric e

of Digimarc's shares was artificially inflated, and relying (directly or indirectly) on Defendants '

false and misleading statements, or on the integrity of the market in which the securities are

:page 119 - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES-LAW

STO! L STOL-L . BRRNr LOK [7NG & SFiLACHTER P .C .

709 S . W :OAK STREETPORTLAP Imo, (7RE GCN 9720 4

TEiL . (503) 227-1600 FAX (503) 227-6840

traded, and/or on the absence of material, adverse information known to or recklessly disregarded

by Defendants (but not disclosed to the public) during the Class Period, Plaintiffs and the other

members of the Class acquired Digimarc common stock during the Class Period at artificially

high prices and were damaged thereby .

219, At the time of said misrepresentations and omissions, Plaintiffs and other members

of the Class were unaware of their falsity, and believed them to be true . Had Plaintiffs and the

other members of the Class and the marketplace known of the true performance, business

practices, future prospects and true value of Digirnarc, which were not disclosed by Defendants,

Plaintiffs and other members of the Class would not have acquired their Digimarc securities

during the Class Period, or, if they had acquired such securities during the Class Period, .they

would not have done so at the artificially inflated prices which they paid .

220 . By virtue of the foregoing, Defendants violated Section 10(b) of the Exchange Act

and Rule J fib-5 promulgated thereunder .

221 . As a direct and proximate result of Defendants' wrongful conduct, Plaintiffs an d

the other members of the Class suffered damages in connection with their acquisition of the

Company's securi : : .es during the Class Period because they purchased these securities at

artificially inflated prices since Defendants' fraudulent statements and scheme caused the market .

to believe that Digirrzarc was a successful company with fast growing revenues and profits . The

artificial i .if[ation ofDigimarc's stock was partially eliminated when the Company revealed on

January 21 . 2004 that revenues. and earnings were going to be substantially lower than Diginlarc

had led dae ifiarket to expect, causing the stock price to drop precipitously and partially correcting

the market's perception of the Company's true, financial condition . In response to the January 20,.

Page ;`)('r- SECOND A%UNDED CLASS ACTION COMPLAINT FOR VIOLATION OF .THE FEDERAL SECURITIES LAS

STOLL STOLL BERNE LOK'I1NO & SHLAC ITER P .C209 SAY . OAF. 5 t REE T

POR: L ANG, OREGON 9120 4TEL . (503 ) 227-1600 FAX (503) 227 6340

2004 announcement, the Company's stock lost approximately 15% of its value on January 21,

2004, dropping from $14 .95 to $12 .78 on unusually high trading volume of 558,200 shares. The

remaining artificial inflation in the price of Digimarc's securities was eliminated on July 28,

2004, when the Company revealed that it .was going to report substantial losses and had

significant financial control problems, which revealed the Company's true financial condition and

corrected the markets misperception of Digimarc as a successful company with growing profits,

again causing a substantial decline in Digimare's stock price. In response to the July 28, 2004

announcement, on July. 29, 2004 Digimarc stock lost approximately 25% of its value, falling fro m

$12.07 to $9 .04 on unusually high trading volume of 653,600 shares .

COUNT II

FOR VIOLATIONS OF SECTION 20(a) OF THE EXCHANGEACT AGAINST INDIVIDUAL DEFENDANTS

222. Plaintiffs repeat the a llegations set forth in the above paragraphs as if set forth

fully herein . This claim is asserted against the Individual Defendants .

223 . Individual Defendants were, and acted as, controlling persons of Digimarc withi n

the meaning of Section 20(a) of the Exchange Act as alleged herein . By virtue of their high level

positions with the Company, participation in and/or awareness of the Company's operations

and/or intimate knowledge of the Company's actual performance, these Defendants had the

requisite power, to directly or indirectly control or influence the specific corporate policy which

resulted in the dissemination of the various statements which Plaintiffs contend are false and

misleading . Individual Defendants were provided with or had unlimited access to the Company' s

reports, press releases, public filings and other statements alleged by Plaintiffs to be false and

Page 12l - SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATION OFTHE FEDERAL SECURITIES LAW

STOLL STOLT.. BERNP C,OKT[NG & SHLACHTEER P.C .209 S .W . OAK STR[:} r

PORTLAND, OREGON 97204TF1 . (503) 227-! 600 FAX (503) 227-6840

misleading prior to and/or shortly after these statements were issued and had the ability to preven t

the issuance of the statements or cause the statements to be corrected .

224 . In addition, Individual Defendants had direct involvement in the day-to-da y

operations of the Company and, therefore, is 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 .

225 . As set forth above, Individual Defendants violated Section 10(b) and Rule lOb-5 b y

their acts and omissions as alleged in this Complaint, By virtue of their controlling positions ,

Individual Defendants are liable pursuant to Section 20(a) of the Exchange Act . As a direct and

proximate result of" these Defendants' wrongful conduct, Plaintiffs and other members of th e

Class suffered damages in connection with their purchases of the Company's securities during th e

Class Period .

PRAYER FOR RELIEF

WHEREFORE, Plaintiffs, on their own behalf and on behalf of the Class, prays fo r

.judgment as follows :

(a) Declaring this action to be a class action pursuant to Rule 23(a) and (b)(3 )

of the Federal Rules of Civil Procedure on behalf of the Class defined herein ;

(b) Awarding Plaintiffs and the other members of the Class damages in an

amount which may be proven at trial, together with interest thereon ;

(c) Awarding Plaintiffs and the members of the Class pre-judgment and post-

judgment interest, as well as their reasonably; attorneys' and experts' witness fees and other costs ;

(d) Ordering an accounting of Defendants' insider trading proceeds ;


STOLL STOLL'3CRNE LOKT]NO & SU[.ACHTER P .C .209 S .W. OAK STREE T

PORTLAND, OREGON 9720 4TEL. (503) 227-1600 FAX (503 ) 227-6840

(e) Awarding preliminary and permanent injunctive relief in favor of Plaintiffs

and the Class against Defendants, including an accounting and the imposition of a constructiv e

trust and/or an asset freeze on Defendants' insider trading proceeds ; and

(f) Such other relief as this Court deems appropriate .

JURY DEMAND

Plaintiffs demand a trial by jury .

Dated this 17th day of January, 2006 .

Respectfully submitted,

STOLL STOLL BERNE LOTKING &SHLACHTER P .C.

BY :Gary M. Berne , OSB No. 77407David F. Rees , OSB No. 94513Mark A. Friel , OSB No. 0025 9209 Southwest Oak Street, Suite 500Portland, OR 97204Telephone: (503) 227-1600Facsimile: (503) 227-6840

and

MILBERG WEISS BERSHAD& SCHULMAN LLP

Lori G. Feldman (admitted pro hac vice)Email : lfeldman@milbergweiss .comOne Pennsylvania PlazaNew York, NY 10119-0165Telephone: (212) 594-5300Facsimile: (212) 868 .1229


STOLL STOLL L3ERNE LOKT[N[i & SI ILACHTER P .C.209 S .W . OAK STREET

PORTLAND, OREGON 9720 4T EL . (503 ) 227 .1600 FAX(503)227-6840

MILBERG WEISS BERSHAD& SCHULMAN LL P

Karen T. Rogers (admitted pro hac vice)Email: krogers@nilbergweiss . com355 South Grand Avenue , Suite 4170Los Angeles , CA 9007 1Telephone : (213) 617-1200Facsimile : (213) 617-197 5

Co-Lead Counselfor Plaintiffs


STOLL S TOLL E3ERNE LOKTE?9G & SE[E :ACHTER P .C .

209 S . W . OAK STREET

PORTLAND, OREtiON 9720 4TEL . (503) 227-1600 FAX (503) 227-6840

k - 1

CERT cAT10yi- OOF-PRQPOSED<T EAD PLA N r11PL1 MY;y T -ID MDERAL, ffC'l=. S••LA.WSS

Rex Boggs'declares the following, as to the. claims asserted, or to be asserted,wader the federal securities ]aws :

1. Ihave-reviewed.the Digimarc•Corporation{Nasdacl: DMRC) co l t-filedby Stoll Stoll Berne f.okting & Shlacbter P .C ., whom I designate as my counsel in-tki is action for 411 purposes,

2, 1 did not acquire Digiimazc Corporation stock at the direction of phdntiff'scounsel or in brdtr to participate in any private action under the federal- securities laws-

3. 1 amwilling to serve as a leadptaintid' .either-individually or as part of agroup. A lead plaintiff is a representative party Who acts onbehalf of other classm,enibers in directing the-action, and whose duties may include tes g at deposition .and trial . .

4. 1 will not accept anypayment for serving as a representative patty beyondmy pro rata share of any recovery, oxccpt reasonable costa and expenses, suclx as lostwages and travel expenses, d ctly related-to the class representation, as ordea'ed orapproved by the court ptimuant to law.

5. I have not sought to serve or served as a represmiative party for a . class inan action under the federal securities laws within-thc past three years .

d . 1 understarxfthattbie is not a claim form, and that my Ability to share inany recovery as a member of the class, is unaffected by .my decision to serve as arepresentative-qty.

7 . During the Class Period I have ntadc-rbe following transactions inDi imsrc Corporation stock, and I will provide records of those transactions uponrequest :

No, of Shares Su. ISel! Date Price Per Was444)0 AII(A v ~l

please use and attach additional pages ifneeessary.

I declare under penalty of perjn y that the foregoing is true and correct .

Executed Us Q,~_ day of4e?b 2004 u~ Co}mty, California .

gsRex b;-

CERTIFICATION OF PROPOS ED L p PLAUNTII"I"

certify that:

1 . 1 have reviewed the complaint and I authorize Milberg Weiss Bershad & Schulman 11 .P to act on my behalf in this matter in applying forLead Plaintiff status and for all other purposes .

2. i did not acquire the security that is the subject of this action at the direction of plaintiff's counsel or in order to participate in this privateaction or any other litigation under the federal securities laws .

3. 1 am willing to serve as a Lead Plaintiff either individually or as part of a group . A Lead Plaintiff is a representative party who acts vn behalf,of other lass members in directing the action, and whose duties may include providing testimony at deposition and trial, if necessary.

q . 1 represent and warrant that I am authorized to execute this Certification on behalf of the purchasers of the subject securities describedherein (including, as the case may be, myself, any co-owners, any corporations or other entities, and/or any beneficial owners) .

S . I will not accept any payments for serving as a representative party on behalf of the class beyond the purchaser's pro rata share of anyrecovery, except such reasonable costs and expenses (including lost wages) directly relating to the representation of the class as orderedor approved by the court .

b . I understand that this is not a claim form, and that my ability to share in any recovery as a member of the class is unaffected by my - .'decision to serve as a representative party or Lead Plaintiff.

7 . The number of shares or other securities of Digimarc Corp . (NASDAQ :DMRC) [ held on the first day of the Class Period, April 17, 2002- (ifany) was :

Type of Security Icheck one) uanti

Common Stock Cl Preferred Stoc k© Bonds U Put

0 Call

8 . 1 have listed below all my transactions in the securities of Digimarc Corp . (NASDAQ :DMRC) during the Class Period as follows :

Type of Security(Common stock, Preferred Stock, Calls, Puts or Bonds

Purchase/Acquisitio nor Sale/Disposition

Quantity Trade Datemm/dd! )

Price perShare/Securl $

7-6 q,

(* List additional transactions on separate sheet, if necessary)

These securities were acquired or held in (check all that apply) :

0 General (non-retirement account) © Merger/acquisition/distribution © Gift❑ IRA ❑ Employer-sponsored plan (401k, 403b, etc . )

9 . X made the following sales of securities of Digimarc Corp . (NASDAQ!DMRC) during the 90-day period after the Class Period:

Sales (July 28 , 2004 to 90 days later )

Type of Security Quantity Trade Date Price perCommon stock, Preferred Stock, Calls Puts or Bands (mmldgLa) Share/Security

10 . During the three years prior to the date of this Certification, t have not sought to serve and I have not served as a representative party fora class in an action filed under the federal securities laws except as described below (if any) :

I declare under penalty of perjury, under the laws of the United States, that the information entered is accurate ,

Executed this J y _ day of L'Y~ `; 20E1 4

Name ( print) ' Signatu re

a

ti `̀

CERTIi I ATTON OF PROPOSED LEAD pI ..AIN13FF

1, _~ , - e,4 LJ4 , certify that :

1. I have reviewed the complaint and I authorize Milberg Weiss Bershad & Schulman LLP to act on my behalf in this matter in applying forLead Plaintiff status and for all other purposes .

2, 1 did not acquire the security that is the subject of this action at the direction of plaintiff's counsel or in order to participate in this privateaction or any other litigation under the federal securities laws.

3. 1 am willing to serve as a Lead Plaintiff either individually or as part of a group . A Lead Plaintiff is a representative party who acts on behalfof other class members in directing the action, and whose duties may include providing testimony at deposition and trial, if necessary .

4. 1 represent and warrant that I am authorized to execute this Certification on behalf of the purchasers of the subject securities describedherein (including, as the case may be, myself, any co-owners, any corporations or other entities, and/or any beneficial owners) .

5. 1 will not accept any payments for serving as a representative party on behalf of the class beyond the purchaser's pro rata share of artyrecovery, except such reasonable costs and expenses (including lost wages) directly relating to the representation of the class as orderedor approved by the court.

6. 1 understand that this is not a claim form, and that my ability to share in any recovery as a member of the class is unaffected by mydecision to serve as a representative party or Lead Plaintiff ,

7. The number of shares or other securities of Digimarc Corp . (NASDAQ: DMRC) I held on the first day of the Class Period, April 17, 2002 (ifany) was :

Type of Security (c heckone) yuantlty

X -Common Stock ❑ Preferred Stock 0❑ Bonds ❑ Put❑ Cal

8 . I have listed below all my transactions in the securities of Digimarc Corp . (NASDAQ:DMRC) during the Class Period as follows:

Type of Securi ty(Common stocfe, Preferred Stock, Calls Puts or Bonds

Purchase/Acquisitio nor Sale/ ills ositfon

Quantity Trade Dat emmddj

Price pe rShare Securi $

(* List additional transactions on separate sheet, if necessary )

These securities were acquired or held in (check all that apply) :

❑ General (non-retirement account ) ❑ M erger/acquisition/distribution ❑ GiftX IRA ❑ Employer-sponsored plan (401k, 403b, etc . )

9. I made the following sales of securities of Digimarc Corp . (NASDAQ :DMRC) during the 90-day period after the Class Period :

Sales (July 28 , 2004 to 90 days later )

Type of SecurityCori mon stock, Preferred Stock, Calls, Puts or Bonds

Quantity Trade Date(mm/ddlyy)

Price pe rShar Securi

10. During the three years prior to the date of this Certification, I have not sought to serve and t have not served as a representative party fora class in an action fled under the federal securities laws except as described below (if any) :

I declare under penalty of perjury, under the laws of the United States, that the information entered is accurate .

Executed this day of bCr.~y-cam 2004

SignatureName (print)

CERTIFICATE OF SERVIC E

I hereby certify that I caused to be served the foregoing SECOND AMENDED CLAS S

ACTION COMPLAINT FOR VIOLATION OF THE FEDERAL SECURITIES LAW o n

the following named person(s) on the date indicated below ,

[ x ] By Regular Mail with postage prepaid[ x ] By Electronic Filing (CM/ECF)

to said person(s) a true copy thereof, contained in a sealed envelope, addressed to said person(s )

at their last known address indicated below :

Barnes H. EllisLois O . RosenbaumSTOEL RIVES LLP900 SW Fifth Avenue, Suite 2600Portland, OR 97204

Attorneys for Defendant s

DATED this 17th day of January, 2006 .

STOLL STOLL BERNE LOKTING & SHLACHTER P .C .

By: .~.

. .

.Gary M. Berne , OSB No . 77407David F. Rees , OSB No. 94513Mark A. Friel , OSB No . 00259Telephone: (503) 227-160 0

and

Lori G. Feldman , (admitted pro hac vice)MILBERG WEISS BERSHAD & SCHULMAN LLPTelephone : (206) 839-0730

Karen T. Rogers , (admitted pro hoc vice)MILBERG WEISS BERSHAD & SCHULMAN LLP355 S. Grand Avenue, Suite 4170Los Angeles, CA 90071Telephone : (213) 617-1200Facsimile : (213) 617-197 5Email : krogers@rnilbergweiss .com

Co-Lead Counsel for Plaintiffs

Page 1 - CERTIFICATE OF SERVIC E

STOLL 5TOLL SEERNE LOKTFNG & SE [L .ACt-tTER P .C.

K 1WDOA1.WanDoc,6 74481001W0074785 .DOC 2E9 SW . OAK-STREETPORTLAND . OREGON 97204

m. berne , osb no. 77407 , osb no . 95413 stoll stoll...

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