TODD J. CAMPBELL, District Judge.
Pending before the Court is Defendant KraftCPAs PLLC ("Kraft")'s Motion to Dismiss for Failure to State a Claim (Docket No. 65), to which Plaintiffs have filed a Response in opposition (Docket No. 75). For the reasons stated herein, Kraft's motion is GRANTED.
This case concerns the circumstances leading to the failure of Tennessee Commerce Bank (the "Bank") on January 27, 2012. Plaintiffs Carolyn Lynn and Grand Slam Master Capital Fund Ltd. ("Plaintiffs") seek to represent a putative class of plaintiffs who purchased common stock in the Bank's parent holding company, the Tennessee Commerce Bancorp, Inc. ("TNCC"), between April 18, 2008, and January 27, 2012 (the "Class Period"). On September 30, 2013, Plaintiffs filed a Second Amended Class Action Complaint ("SAC"), which asserts claims against TNCC, several former officers of TNCC (the "Individual Defendants"), and Kraft, which served as TNCC's and the Bank's independent outside auditor during the Class Period. With respect to Kraft, Plaintiffs assert a single count under § 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78a et seq, and 17 C.F.R. § 240.10b-5 ("Rule 10b-5") promulgated thereunder. Kraft has moved to dismiss this claim for failure to state a claim.
TNCC, which is headquartered in Franklin, Tennessee, acted as the holding company for the Bank. The Bank offered retail and commercial banking services to small- and medium-sized businesses in the Nashville area. Kraft acted as TNCC's independent external auditor from 2006 through the Bank's closure in January 2012.
According to the SAC, from about 2007 forward, TNCC systemically disregarded its own loan underwriting policies and guidelines, failed to implement sufficient "internal controls" to monitor and evaluate the Bank's loan portfolio for degradation in loan quality and credit risk, and disregarded regulations and laws concerning the recognition and mitigation of losses.
Notwithstanding the economic downturn that began in 2008, the Bank continued to issue increasingly risky loans in sectors of the economy that were impacted severely by the recession (construction and development, commercial real estate, and manufacturing, among others). Many of these loans were essentially uncollectible. By 2008, TNCC's concentration of commercial and industrial ("C&I") loans had reached 539% of total capital, while responsible peer entities were limiting their C&I portfolio to about 100% of total capital. To make matters worse, during the Class Period, the Bank originated more than $400 million in additional loans, growing its portfolio by about 40%, even as responsible peers were restraining their lending.
Even as the Bank continued to issue risky loans and failed to implement necessary internal controls, TNCC and the Individual Defendants reassured investors that the Bank's financial situation was actually improving (when in fact the opposite was true) and misrepresented the quality of its loan portfolio to investors. As discussed herein, an accounting term called the "allowance for lean and lease losses" (the "ALLL") approximates the portion of a lender's total loan portfolio that is impaired or otherwise not likely to be collected in the future. Discounting the present value of a loan portfolio by the ALLL provides a more accurate representation of a company's present financial status.
During the Class Period, Kraft served as the external auditor for the Bank.
Plaintiffs allege that Kraft failed to comply with GAAS when it stated, in its audit letters, that TNCC's financial statements complied with GAAP and were free of material misstatement. Plaintiffs allege that Kraft ignored numerous "red flags" of potential financial impropriety by TNCC and its officers. In particular, during the Class Period, the Federal Deposit Insurance Corporation ("FDIC") provided ongoing supervisory oversight of the Bank in compliance with federally mandated oversight requirements, in the course of which it identified potential problems at TNCC and the Bank.
Plaintiffs allege that Kraft should be held liable for securities fraud because it failed to probe the reliability of the Bank's financial statements in the face of increasing "red flags" of likely financial impropriety. Plaintiffs' allegations and brief (as they relate to Kraft) take a "kitchen sink" approach, making it somewhat difficult to follow which statements Plaintiffs believe that Kraft should have amended, when, and in what manner. As best the Court can discern, Plaintiffs believe that Kraft should have realized at least by mid-2011 that TNCC had misstated the ALLL in its 2010 10-K and in the 10-K forms for previous years. The actual allegations of conduct by Kraft are sparse. In relevant part, Kraft performed a full audit relative to the 2007 and 2008 financials for the Bank, but it did not conduct an internal controls audit for fiscal years 2009 and 2010. The Bank failed in January 2012, well before TNCC's 2011 financial statements were due.
In connection with TNCC's 2009 10-K filing, Kraft provided the following audit letter:
2009 10-K at F-3 (emphases added).
Furthermore, in a section of the 10-K drafted and attested to by management, TNCC states:
Id. at F-2 (emphases added).
In the 2010 10-K, filed on April 18, 2011, TNCC included the same disclaimer as the 2009 report, to the effect that the annual report "does not include an attestation report" by Kraft and that TNCC's management, based on its own assessment, "believes that the Corporation maintained effective internal control over financial reporting as of December 31, 2010." However, in contrast to Kraft's 2009 Audit Letter, Kraft issued a qualified audit letter in connection with the 2010 fiscal year financial report (the "2010 Audit Letter"). The letter states as follows:
2010 10-K at F-3 (emphases added).
Note 12 to the 10-K, which Kraft's 2010 Audit Letter references, describes the August 2010 FDIC examination and the FDIC's March 17, 2011 report concerning that examination. Note 12 discloses, among other things, that the FDIC had deemed the Bank to be in "troubled condition," that the FDIC would be pursuing formal enforcement action, and that the results of the enforcement action could include requirements that the Bank increase its capital ratios, improve asset quality, improve liquidity, address potential regulatory violations, and increase the level of loan and lease loss allowance. (2010 10-K at F-30 to F-31.) Furthermore, Note 12 (prepared by TNCC) states as follows:
Id. (emphasis added).
On May 24, 2011, TNCC signed the Consent Order, which was effective May 25, 2011. In most relevant part, the Consent Order contains a section related to "Allowance for Loan and Lease Losses." In full, that section states as follows:
Consent Order ¶ 7.
On June 1, 2011, TNCC filed a Form 10-K/A, in which it disclosed that it had entered into the Consent Order. With respect to the Consent Order, TNCC states as follows:
2010 Form 10-K/A, revised and filed June 1, 2011.
Note 12 to the revised financial statement includes additional detail concerning the Consent Order. It reiterates that the Consent Order "ended a period of regulatory uncertainty concerning the adequacy of the Bank's ALLL following a joint examination of the Bank conducted by the FDIC and the TDFI in August 2010," and that the Consent Order "does not require any specific increase in the Bank's ALLL and no restatements of the Bank's or Company's financial statements is required." The note also contains bullet points outlining the terms of the Consent Order, including the requirement that "[t]he Bank must maintain an adequate ALLL that is consistent with generally accepted accounting principles and supervisory guidance" and that "the Bank's Board is required to review the adequacy of the Bank's ALLL." The revised 2010 10-K included an unqualified audit letter from Kraft, which states as follows:
2010 Revised Audit Letter, filed June 1, 2011 (emphases added).
In June 1, 2011, concurrent with filing its revised 2010 10-K, TNCC filed a revised 2010 8-K, which attached a full copy of the Consent Order. (See 8-K/A, Ex-10.1.)
In or soon after September 2011, months after Kraft had issued its revised audit letter relative to fiscal year 2010, the FDIC ordered the Bank to restate its all ALLL by about $83 million. On November 1, 2011, the Bank filed a Form 8-K, in which it disclosed that the Bank's quarterly statement for the quarter ending June 30, 2011 "should no longer be relied upon" because TNCC expected to increase its stated ALLL by approximately $83 million as a result of the ongoing FDIC investigation. TNCC disclosed that the adjustments would cause the Bank to be critically undercapitalized. TNCC also disclosed that management had concluded that TNCC disclosure controls and procedures and internal control over financial reporting were not in fact effective as of June 30, 2011. Docket No. 70, Ex. 9, Form 8-K, Item 4.02.
On January 20, 2012, the Bank filed another Form 8-K, in which it disclosed that TNCC had identified issues that would likely impact previous financial statements. TNCC stated that it was conducting a forensic review and that previous financial statements should "not be relied upon at this time." In most pertinent part, TNCC stated as follows:
Form 8-K, Item 4.02 (filed January 20, 2012) (emphasis added).
On January 25, 2012, TNCC filed a copy of a January 23, 2012 letter from Kraft concerning Kraft's previous audit statements. In the letter, Kraft states:
Form 8-K/A, Ex. 99.1, filed January 25, 2012. Two days later, TDFI closed the Bank and appointed the FDIC as receiver. See Form 8-K, filed January 30, 2012.
The SAC alleges that the Individual Defendants deceived investors and the public in order to line their own pockets through significant salaries and bonuses, excessive perks, and stock options, even as they were driving the company into the ground.
By contrast, Plaintiffs do not allege any motive for Kraft's alleged failure to heed "red flags" of potentially fraudulent activity, nor is a motive self-evident in the SAC. Plaintiffs make no specific allegations concerning Kraft's access to information about TNCC and the Bank or that Kraft actually knew about the inner workings of the TNCC and the Bank. Plaintiffs do not allege that Kraft actually knew that TNCC or the Bank had engaged in financial impropriety or that any "whistleblowers" provided Kraft with information that fraud might be occurring at TNCC or the Bank.
Kraft has moved to dismiss the single count against it, contending that Plaintiffs have not met the exacting standard required to a state a claim of securities fraud against an outside auditor. Kraft primarily argues that Plaintiffs' allegations are insufficient to establish the high degree of scienter required to support a securities fraud claim. Kraft also argues that Plaintiffs have failed to plead loss causation against it. In response, Plaintiffs argue that Kraft ignored a litany of "red flags" that should have placed Kraft on notice that the financial statements contained false information, particularly that TNCC was materially and consistently understating ALLL in the years before the Bank collapsed. Plaintiffs also argue that their allegations against "the defendants" (without distinguishing Kraft) are sufficient to plead loss causation generally. Kraft did not file a Reply.
Securities fraud claims under § 10(b) must satisfy the pleading requirements of Fed. R. Civ. P. 9(b). Ernst & Young., 622 F.3d at 478. Thus, a plaintiff's complaint must "(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent." Id.
In addition to the underlying substantive and procedural requirements, the PSLRA imposes additional and more exacting pleading requirements in a securities fraud case. Id. The Supreme Court has created a three-part test for assessing the sufficiency of a plaintiff's scienter allegations: (1) a court must accept all factual allegations in the complaint as true; (2) a court must consider the complaint in its entirety and decide whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard; and (3) assuming that the plaintiff's allegations create a powerful or cogent inference of scienter, a court must compare this inference with other competing possibilities, allowing the complaint to go forward only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged. In re: Omnicare, Inc. Securities Litigation, ___ F.3d ___, 2014 WL 5066826 (6
Under the PSLRA's heightened pleading requirements, any private securities complaint alleging that the defendant made a false or misleading statement must: (1) specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed; and (2) state with particularly facts giving rise to a "strong inference" that the defendant acted with the required state of mind. 622 F.3d at 478 (citing 15 U.S.C. § 78u-4(b)(1), (2)). "The PSLRA `requires plaintiffs to state with particularity both the facts constituting the alleged violation, and the facts evidencing scienter, i.e., the defendant's intention to deceive, manipulate, or defraud.'" Id. (quoting Tellabs, Inc, v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007)). Congress adopted a "strong inference" standard in order to "raise the bar for pleading scienter," Ernst & Young., 622 F.3d at 478 (citing Tellabs, 551 U.S. at 323-24) (emphasis added), although it left the state of mind required to prove the claim intact. Ernst & Young, 622 F.3d at 478.
In general, liability for securities fraud must be premised on at least "reckless" behavior. Id. The Sixth Circuit explains the recklessness pleading standard as follows:
Ernst & Young, 622 F.3d at 478-79.
On top of the exacting baseline statutory pleading requirements, "[t]he standard of recklessness is especially stringent when the defendant is an outside auditor." Id. (citing PR Diamonds, 364 F.3d at 693); see also Ley v. Visteon Corp., 543 F.3d 801, 814-15 (6th Cir. 2008); Fidel v. Farley, 392 F.3d 220, 227 (6th Cir. 2004), overruled on other grounds, Tellabs, 551 U.S. 308 (2007).
Ernst & Young, 622 F.3d at 479 (internal quotations, citations, and brackets omitted); accord PR Diamonds, 364 F.3d at 693-94 ("When the standard of recklessness for auditor is overlaid with the pleading requirements of the PSLRA, a simple rule emerges: to allege that an independent accountant or auditor acted with scienter, the complaint must allege specific, highly suspicious facts and circumstances available to the auditor at the time of the audit and allege that these facts were ignored, either deliberately or recklessly.") (quoting In re SmarTalk Teleservices Sec. Litig., 124 F.Supp.2d 505, 515 (S.D. Ohio 2000)).
The Sixth Circuit has narrowly defined the types of conduct that will meet this exacting recklessness standard for claims against an outside auditor:
Ernst & Young, 622 F.3d at 481 (internal quotations, citations, and brackets omitted); see also PR Diamonds, 364 F.3d at 684.
Within the Sixth Circuit, the scienter test is subject to a "`totality of the circumstances test,' whereby the alleged facts collectively must give rise to a strong inference of actual knowledge or recklessness." Ernst & Young, 622 F.3d at 479 (quoting PR Diamonds, 364 F.3d at 683). The court must consider the complaint in its entirety. Ernst & Young, 622 F.3d at 485.
Id. at 479 (emphasis in original) (internal citations, quotations, and brackets omitted).
Furthermore, the Sixth Circuit has taken a dim view of claims against outside auditors premised on the auditor's failure to respond to purported "red flags" that a plaintiff alleges "should have triggered a higher degree of scrutiny." See id. at 482.
Id. (emphasis added) (internal quotations, citations, and brackets omitted); accord Ley 543 F.3d at 816-17 (rejecting "another attempt to couch alleged GAAS violations as evidence of scienter"); PR Diamonds, Inc., 364 F.3d at 684 ("While the allegations no doubt merit drawing some inference of scienter, that is not enough. The PSLRA requires the Complaint to establish a strong inference [of scienter] . . . .") (emphases in original).
Plaintiffs allege that Kraft violated Generally Accepted Auditing Standards ("GAAS") with respect to certain audit letters related to TNCC's financial statements.
Plaintiffs also contend that Kraft failed follow GAAS factors related to identifying the risk of fraud and misstatement, including the following provisions:
As Plaintiffs acknowledge, many of the auditing requirements did not apply to Kraft's 2009 and 2010 audits, wherein Kraft conducted only financial statement audits, not complete audits. With respect to financial statement audits, the plaintiffs contend that Kraft was at least bound by AU § 325, which states in most relevant part as follows:
AU § 325.
As discussed above, within the Sixth Circuit, pleading a viable securities fraud claim against an outside auditor is a daunting task, particularly based on a "red flags" theory of recklessness. As explained herein, Plaintiffs have not satisfied their burden and the claims against Kraft will be dismissed.
Kraft argues that Plaintiffs' reliance on statements in the Material Loss Review is insufficient as a matter of law to establish scienter. First, the two referenced out-of-circuit cases do not support the proposition that reliance on a material loss review is necessarily insufficient as a matter of law; indeed, the court's discussion of scienter in each of those two cases turned on the specifics of the statements in each material loss review as they related to particular defendants, not on the grounds that a material loss review cannot, in general, support a securities fraud claim. See In re Franklin Bank Corp. Sec. Lit., 782 F.Supp.2d 364, 394 (S.D. Tex. 2011); Cho v. UCBH Holdings, 2011 WL 3809903 (N.D. Cal. May 17, 2011). The Court's analysis here proceeds along similar, unremarkable grounds: the Court evaluates the relevance of particular events set forth in the MLR, at least to the extent those events reflect facts that were contemporaneously communicated to (or directly involved) TNCC and the Bank.
Kraft also contends that the MLR did not conclude that fraud was committed or that anyone (TNCC or its external auditors) had made material statements. The Court agrees that the MLR does not contain any reference to potential fraud or misstatements by Kraft, at least. However, as to TNCC, the Bank, and the Individual Defendants, it is a closer question as to what inferences (if any) reasonably may be drawn from statements in the MLR. Because the Court need not reach that question as it relates to those settling Defendants, the Court expresses no opinion about the MLR as it relates to allegations of fraud against those Defendants.
Finally, Kraft argues that misstatement of the ALLL cannot support a fraud claim because it is an opinion about future events that falls within the "safe harbor" for "forward-looking statements" set forth in 15 U.S.C. § 78u-5(c)(1). In response, Plaintiffs contend that (1) the ALLL is not a "forward-looking statement" within the meaning of the PSLRA's safe harbor provision, (2) even if the ALLL is a forward-looking statement, the safe harbor provision does not protect a company that makes a knowingly false statement of the ALLL, where a company deliberately or recklessly misstates or omits contemporaneous facts that render the ALLL representation to be false; and (3) the safe harbor provision does not apply to financial statements purportedly made in conformance with GAAP.
As to the third of these arguments: Section 78u-5(c)(1) provides that, "[e]xcept as provided in subsection (b) of this section," a securities fraud claim will not lie if a forward-looking statement is either (1) identified as forward-looking and accompanied by meaningful cautionary statements, or (2) immaterial. However, subsection (b) states that the safe harbor provisions do not apply to "a forward-looking statement . . . that is . . . included in a financial statement prepared in accordance with generally accepted accounting principles."
Here, TNCC specifically represented in the 10-K disclosures at issue that the ALLL was presented in conformance with GAAP. Thus, even assuming arguendo that the ALLL is a forward-looking statement, TNCC's representations in their 10-K financial statements categorically exempt those statements from the PSLRA's safe harbor provision.
Having cleared the brush, the remaining question is whether Plaintiffs have adequately pleaded facts supporting the requisite degree of scienter to support a securities fraud claim against Kraft. Although Plaintiffs' SAC and brief in opposition to the Motion to Dismiss list a hodge-podge of alleged "red flags" spanning the period from 2007 to 2011, Plaintiffs do not identify precisely when they believe Kraft first acted recklessly by failing to heed these alleged indicia of fraud. At any rate, Plaintiffs' best argument relates to Kraft's issuance of a (revised) unqualified audit letter in June 2011 relating to the TNCC's 2010 financial statement. Indeed, Plaintiffs laud Kraft for initially issuing a qualified audit statement in April 2011 with respect to TNCC's 2010 Form 10-K, but fault Kraft for issuing an unqualified audit statement concerning those financials in June 1, 2011, when Kraft represented (as did TNCC) that the Consent Order "ended" any concerns related to the Bank's 2010 ALLL estimate.
First, Plaintiffs contend that Kraft committed numerous GAAS violations, including a reckless failure to probe the accuracy of the company's methodology supporting the ALLL. Although Plaintiffs reference numerous potential failures by Kraft to perform a sufficiently thorough audit of the Bank's finances under traditional GAAS principles, the fact is that Kraft expressly performed only a financial statement audit, not a complete audit, in connection with the 2009 and 2010 financial statements. Kraft's 2009 and 2010 audit letters explicitly disclosed that its role was limited, that it was relying on management's representations concerning internal controls, and that Kraft therefore expressed no opinion concerning the adequacy of those controls. Indeed, in a different section of the Form 10-K, TNCC represented that the company had vetted its own internal controls, that the controls were adequate, and that it had not asked its outside auditor to vet those controls.
Given Kraft's limited engagement by TNCC relative to the 2009 and 2010 financial statements, it would be unreasonable to infer that Kraft had access to or should have reviewed TNCC's records relating to internal controls, let alone that Kraft, during its audit, deliberately or recklessly ignored "obvious" or "egregious" signs that the internal controls were inadequate.
Plaintiffs also point to numerous other alleged "red flags," including (1) Fort's lawsuit against the Bank, (2) the FDIC investigations of the Bank, which reported various forms of potential impropriety (generally of increasing severity) from 2007 through the Bank's failure in January 2012, including allegations relating to the lack of internal controls, (3) the Bank's flawed business model, which involved issuing increasingly more risky loans, (4) the FDIC's announcement in March 2011 that it intended to pursue formal enforcement action, including a potential reduction to the 2010 ALLL, and (5) the agreement to the Consent Order in May 2011, which included a requirement that the Bank accurately state its ALLL going forward.
With respect to Fort's lawsuit, the case was settled and voluntarily dismissed in October 2010 without any merits rulings by the district court. In the absence of any adverse findings against TNCC, there was no reason to believe that Fort's allegations were true. Moreover, after the FDIC investigated Fort's allegations, the FDIC took no action. Thus, the fact of Fort's allegations did not a constitute an "obvious" indication of financial fraud at TNCC, at least relative to Kraft.
As to the remaining "red flags", which make more sense when construed collectively and in context, the facts do not support a "strong inference" that Kraft ignored such obvious indications of financial fraud as to be essentially complicit in TNCC's alleged fraud. Certainly, the FDIC identified concerns with respect to TNCC's business model and its calculation of the ALLL. In particular, in March 2011, it informed TNCC that the ALLL likely needed to be adjusted by about $16 million and that it would likely seek to require TNCC to conform its ALLL methodology with FAS 5 and FAS 114 going forward. One week later, the Board responded by vigorously disputing the FDIC findings concerning TNCC's ALLL. When Kraft issued its qualified audit letter one month later, it appropriately disclosed that, even subject to its limited engagement to conduct a financial statement audit, it could not represent that the ALLL was accurate in light of the FDIC's recent report, the implications of which Kraft appropriately stated were "unresolved."
For whatever reason, in the Consent Order that the Board signed on May 25, 2011, the FDIC relented on its earlier recommendation of an adjustment to the 2010 ALLL, and instead chose only to require TNCC to ensure that ALLL was calculated in accordance with FAS 5 and FAS 114 going forward. Although Plaintiffs here suggest that Kraft should have construed that prospective recommendation as indicating that TNCC had committed fraud with respect to the 2010 ALLL, the Court finds no reason why Kraft should have drawn that conclusion. The language talks about the future, not the past.
Furthermore, given the sequence of events, one could understand why Kraft would have construed the Consent Order's silence concerning TNCC's previous statement of ALLL as an implicit indication that the regulators did not believe that a past adjustment was required. In its response to the FDIC and in its April 2011 public filings concerning the 2010 financials, TNCC had repeatedly stated that it disagreed with the FDIC's March 2011 report of examination, that it believed that TNCC's methodologies and financial statements (including its calculation of the ALLL) were accurate and intended to "vigorously appeal" that FDIC's findings. The FDIC had discretion to implement the remedies that it believed were justified and necessary, including ordering adjustments to the 2010 ALLL (or earlier periods). The FDIC also investigated TNCC multiple times and engaged in a dialogue with TNCC about what to do next. Nevertheless, it declined to order any previous adjustments to the ALLL in the May 2011 Consent Order. Under the circumstances, the terms of the Consent Order did not constitute an "obvious" red flag to Kraft of previous financial fraud by TNCC with respect to the ALLL. Indeed, to the contrary, Kraft plausibly could have construed it as reflecting the regulators' satisfaction with the previous statement of the ALLL. At any rate, even if Kraft took a relatively generous view of the Consent Order as "ending" the "period of uncertainty" relative to the 2010 ALLL, the terms of the Consent Order were made public on the same day as Kraft's revised unqualified letter, and Kraft expressly stated (again) that it had not been engaged to investigate, and therefore expressed no opinion concerning, the adequacy of the company's internal controls over financial reporting. Kraft disclosed the extent of, and limitations on, its knowledge of TNCC's financials, and none of these circumstances suggests any type of cover-up, "willful blindness," or a reckless refusal by Kraft to probe obvious indications of fraud.
The record also suggests that Kraft acted appropriately when the regulators determined, in late 2010, that immediate adjustment to ALLL was required. Kraft withdrew its 2010 audit letter and indicated that it might also withdraw previous audit letters. Kraft also raises the valid point that, in the absence of more information, it is plausible that the loans subject to the $83 million adjustment in Fall 2011 were not among the loans addressed in the 2010 statement of ALLL. Indeed, Plaintiffs allege that TNCC continued to engage in a loaning spree in 2011 (i.e., after the 2010 fiscal year) and restructured a number of loans in the Summer of 2011, which could have been the loans for which the adjustment was required.
More broadly, Plaintiffs have not pleaded any particular conduct or motivation by Kraft that would support an inference of scienter. Plaintiffs do not allege that Kraft had any specialized access to TNCC's or the Bank's financial records (particularly in 2009 and 2010), that Kraft actually knew of impropriety and chose to ignore it, or that Kraft had any particularized knowledge about the Bank's operations beyond its basic obligations as an external auditor. Perhaps most importantly, Plaintiffs do not allege why Kraft allegedly would have acted with such recklessness that it effectively assisted TNCC and its officers in engaging in securities fraud. The absence of particularized factors weighs against a strong inference of scienter.
On the other hand, Plaintiffs do have a point that several GAAS "risk factors" for fraud were present as of June 2011. Plaintiffs' allegations establish that, in hindsight, the Board did not have effective audit committee oversight over the Bank's internal controls (AU § 316.85), and that the Bank may have utilized relaxed lending procedures, made related-entity transactions, experienced rapid growth compared to its peers, and experienced unusually large growth of its loan portfolio without a commensurate increase in the size of the allowance for loan and lease losses (AAG-DEP 51.128 at pp. 118-119) — all of which are risk factors fraud. Again, given the limited scope of Kraft's 2009 and 2010 financial statement audits, it is not clear that Kraft would or should have known about the Bank's internal controls. At any rate, at most, a reasonable person could infer from these allegations that Kraft should have exercised more professional skepticism before issuing a unqualified audit letter on June 1, 2011 relative to the 2010 10-K, and perhaps never should have issued an unqualified audit letter without actually testing the Bank's internal controls. Again, however, violations of GAAS alone are insufficient to establish the requisite degree of scienter.
Taken cumulatively, the allegations against Kraft could, at most, support a claim that Kraft acted negligently. However, the allegations do not meet the exceedingly high standard of "recklessness" applicable to claims against an outside auditor, because they fail to support a "strong inference" of scienter by Kraft. Thus, a reasonable person would not "deem the inference of scienter cogent" in the first place. See Ernst & Young, 622 F.3d at 479.
Furthermore, even if a reasonable person could draw a "strong inference" of scienter from the facts at issue, that inference as not as compelling as non-culpable explanations for Kraft's conduct. The record does support an inference that TNCC limited Kraft's role with respect to the 2009 and 2010 financial statements, perhaps in an effort to prevent Kraft from uncovering evidence of fraud. Furthermore, Kraft appears to have drawn reasonable inferences from management's express representations and from the recommendations of the regulators concerning TNCC's 2010 ALLL, under circumstances in which the regulators may have had more access to the underlying methodologies than Kraft. The inference that Kraft so "egregiously" refused to "see the obvious" or "investigate the doubtful" is not as compelling as the inference that Kraft acted innocently, or at worst negligently, in issuing an unqualified audit letter in June 2011.
This case involves circumstances even less compelling than those presented in several Sixth Circuit cases affirming the dismissal of claims against an outside auditor. In Fidel v. Farley, for example, the plaintiffs claimed that Fruit of the Loom's external auditor, Ernst & Young, should be held liable for securities fraud for providing unqualified audit statements despite numerous "red flags." 392 F.3d at 228. The plaintiff alleged that: (1) the auditor knew that a securities fraud lawsuit had been filed against the company; (2) the auditor had first-hand knowledge of the company's "demonstrated propensity to skirt the financial rules"; (3) the auditor received an anonymous letter detailing certain financial misstatements occurring within the company; (4) the auditor knew that the company was extending unusual rights to its customers; and (5) the company's management "demonstrated numerous risk factors," including "an excessive interest by management in maintaining or increasing" the company's stock price or earnings trend through use of unusually aggressive accounting practices. Id. at 228-29. Notwithstanding these significant indications of potential fraud, the Sixth Circuit affirmed the district court's holding that the allegations were insufficient to establish the requisite degree of scienter. Id. at 229-230. Indeed, the Sixth Circuit concluded that "[t]hese red flags simply do not create the inference, much less a strong inference, that Ernst & Young, in preparing an audit report of 1998 financial results, acted with scienter." Id. at 229.
Similarly, in PR Diamonds, the Sixth Circuit found that the following alleged circumstances did not support a finding of scienter against the external auditor: (1) the client committed significant GAAP violations; (2) the auditor was aware of, but ignored, numerous internal control deficiencies by the client; (3) the accounting violations were simple, obvious, and involved large-scale fraud; (4) the auditor had unfettered access to the company's confidential information throughout the class period; and (5) the auditor was warned that the accounts receivable reserve was understated. 364 F.3d at 693-96.
In Ernst & Young, the circumstances were even more serious. There, the plaintiffs alleged that the outside auditor was aware of numerous red flags: (1) the financial statements at issue reflected numerous GAAP violations; (2) the auditor knew but ignored the fact that management altered certain numbers; (3) the auditor knew that the company had a history of serious accounts receivable collection problems; (4) the auditor knew or should have known that a material portion of the accounts receivable was uncollectible; and (5) the company had sued the auditor because the lead auditor had admitted to the company that "there was a problem." 622 F.3d at 474-476, 481-484. Applying the stringent pleading standard, the Sixth Circuit affirmed the district court's conclusion that these allegations were not sufficiently specific to raise a strong inference of scienter relative to the external auditor. Id. at 483.
Here, the circumstances are even less compelling than those at issue in Fidel, PR Diamonds, and Ernst & Young. Therefore, Plaintiffs' claim against Kraft will be dismissed with prejudice for failure to support the requisite degree of scienter. Because the Court finds that dismissal is appropriate on this basis alone, the Court need not address Kraft's argument that Plaintiffs have failed to prove loss causation.
For the reasons stated herein, Kraft's Motion to Dismiss is granted and Plaintiffs' claim against Kraft is dismissed with prejudice.
IT IS SO ORDERED.
In response to Plaintiffs' combined opposition brief, Individual Defendants Perez, Sapp, and TNCC filed a Reply (Docket No. 81), Individual Defendant Cox filed his own Reply (Docket No. 82), and Individual Defendant Helf filed his own Reply (Docket No. 83). Understandably, none of these reply briefs directly addresses Plaintiffs' opposition brief as it relates to Kraft, although (collectively) they do discuss loss causation as it relates to TNCC and each Individual Defendant.
