DOUGLAS P. WOODLOCK, UNITED STATES DISTRICT JUDGE.
I. FACTUAL BACKGROUND...419
A. Shengda's Note Offering and the Plaintiffs' Purchases...419
B. KPMG-HICs Realization of Shengda's Overvaluation and Shengda's Bankruptcy...420
C. Alleged Misrepresentations by KPMG-HK...421
D. Impact of Misrepresentations on the Plaintiffs...422
II. PROCEDURAL HISTORY...422
III. STANDARD OF REVIEW...425
IV. DISCUSSION...425
A. Section 18 Claim...425
B. Negligent Misrepresentation Claim...449
IV. CONCLUSION...453
Plaintiffs Miller Investment Trust ("Miller") and Jura Limited ("Jura") seek to recover investment losses from purchases of $8.7 million of bonds offered by ShengdaTech, Inc. ("Shengda") made between December 2010 and February 2011. In March 2011, it was reported that Shengda had vastly overstated its revenues. Shortly thereafter, Shengda defaulted and declared bankruptcy. In December 2011, Miller brought this action alleging securities fraud against Defendants Morgan Stanley, which underwrote the offering, and KPMG Hong Kong ("KPMG-HK"), Shengda's auditor. The Plaintiffs allege that Morgan Stanley and KPMG-HK knew or should have known about misrepresentations of material fact made in the offering documents provided to the Plaintiffs on which Plaintiffs relied in deciding to purchase the Shengda bonds.
I recount the facts as alleged in the Third Amended Complaint as true, focusing primarily on those allegations pertaining to KPMG-HK.
Shengda was a Nevada corporation with its principal place of business in the People's Republic of China. Third Am. Compl. (TAC) ¶ 37. Before its bankruptcy, Shengda primarily manufactured a chemical additive called nano-precipitated calcium carbonate, which is used to improve industrial materials such as paint, paper, plastic, and rubber. Id. It conducted its manufacturing operations through Chinese subsidiaries.
In 2010, Shengda sold an aggregate of $130 million of 6.5% senior convertible notes due in 2015 through a private placement offering closing in December 2010. TAC ¶¶ 1, 16, 219, 224. In connection with the offering, Morgan Stanley,
After receiving additional assurances from KPMG-HK as to the use of its audit reports and the accuracy of Shengda's financial statements, Morgan Stanley distributed the PPM to potential buyers, including Wellesley Investment Advisors, Inc. TAC ¶¶ 2, 23, 34, 220, 243, 258. Wellesley Investment Advisors is a registered investment adviser in Massachusetts that manages Miller, a mutual fund, and has full investment authority over the funds of Jura, a Bermuda corporation. Id. ¶¶ 28, 30-31. Relying on the information provided in the PPM and in Shengda's SEC filings, Miller purchased approximately $8 million of Shengda bonds (Shengda's 2015 Notes) between December 10, 2010 and February 16, 2011,
In conducting its audit for Shengda for fiscal year 2010, KPMG-HK conducted additional procedures that it had allegedly assured the chair of Shengda's Audit Committee it would perform. TAC ¶¶ 17, 166. On March 1 and 2, 2011, KPMG-HK began contacting Shengda's customers, suppliers, and banks using publicly available contact information, and learned that many of Shengda's claims regarding business relationships and financial statements were false. Id. ¶¶ 17, 225-226. Specifically, KPMG-HK "could not confirm sales amounts, sales terms, and outstanding balances, discovered that many documents ShengdaTech provided to KPMG were crude forgeries, discovered that certain transactions had been with related parties without necessary disclosure, and that suppliers and customers denied engaging in business with ShengdaTech." Id. ¶ 226. The Plaintiffs contend that KPMG-HK would have discovered these issues earlier had it conducted its 2008 and 2009 audits consistent with governing auditing standards. Id. ¶ 227.
Beginning on March 2, 2011, and through a series of three memoranda thereafter, KPMG-HK informed Shengda's Audit Committee of its discovery of "potentially serious discrepancies and unexplained issues" during its audit of Shengda's financial statements for fiscal year 2010. TAC ¶¶ 226-227. Shengda immediately convened a special committee, composed of the independent directors on the Audit Committee and advised by a law firm and an accounting firm, to conduct an internal investigation. Id. ¶¶ 228-229. On March 14, NASDAQ suspended trading in Shengda's equity securities, thereafter stating that it would not resume trading until Shengda had "fully satisfied NASDAQ's request for additional information." Id. ¶¶ 230, 232. The next day, Shengda issued a press release announcing the appointment of the special committee "to investigate potentially serious discrepancies and unexplained issues relating to the Company and its subsidiaries' financial records." Id. ¶ 231.
In April 2011, KPMG-HK resigned as Shengda's auditor, stating that it had "doubts about management's representations provided to [KPMG-HK] in connection with [its] 2008 and 2009 audits of the consolidated financial statements and the effectiveness of internal control over financial reporting of the Company." TAC ¶ 233. KPMG-HK implored Shengda to make disclosures regarding any errors in previously issued audit reports to prevent future reliance on them. Id.
On May 5, Shengda filed a current report on Form 8-K with the SEC, stating that "KPMG previously informed the Company's Audit Committee of certain concerns arising during its incomplete audits of the Company's consolidated financial statements as of and for the year ended December 31, 2010, and the effectiveness of internal control over financial reporting as of December 31, 2010." TAC ¶ 234. It went on to identify issues related to bank balances, supplier transactions, VAT tax invoices, third-party sales and payments, customer sales, and the confirmation process. Id.
On June 9, Shengda announced that it was in default on the convertible bond securities issued in the 2010 private placement; the next day, all trading of Shengda stock was suspended by NASDAQ. TAC ¶¶ 235-236. The SEC thereafter commenced a regulatory proceeding resulting
On August 19, Shengda filed a Chapter 11 bankruptcy petition and an adversary proceeding against its Chief Executive Officer, Ziangzhi Chen, to prevent him from interfering with the restructuring.
The Plaintiffs allege that the offering documents in the PPM on which they relied in purchasing the Shengda bonds contained material misrepresentations that made Shengda appear far more stable financially than it was. TAC ¶¶ 22, 26, 32, 61, 62. Further, they contend that KPMGHK, as Shengda's auditor (and Morgan Stanley as Shengda's underwriter), "had access to ShengdaTech's internal reports and other data and information about those companies' finances, operations and sales at all relevant times," and failed to perform its auditing responsibilities adequately, such that it would have discovered Shengda's fraud, in light of this information. Id. ¶¶ 6, 246.
Specifically, the Plaintiffs assert that KPMG-HK made two materialy false statements:
First, regarding its own compliance with Public Company Accounting Oversight Board ("PCAOB") standards in auditing Shengda's financial statements; and
Second, regarding Shengda's compliance with generally accepted accounting principles ("GAAP") in preparing its financial statements. The Plaintiffs contend that KPMG-HK knew or should have known that these statements were false. TAC ¶¶ 59-61.
KPMG-HK's statement of PCAOB compliance appears in its audit reports for fiscal years 2008 and 2009, dated March 31, 2009 and March 15, 2010, respectively, and in its internal control audit report for fiscal year 2008, also dated March 31, 2009. TAC ¶¶ 34, 59-61; 2008 Audit Report; 2009 Audit Report; 2008 Internal Control Audit Report. KPMG-HK's statement of GAAP compliance also appears in its audit reports for fiscal years 2008 and 2009.
The Plaintiffs allege that they relied to their detriment on the misrepresentations and omissions of KPMG-HK and Morgan Stanley in the documents that led the Plaintiffs to purchase the Shengda notes. TAC ¶¶ 20-22, 26, 32. According to the Plaintiffs, the materially false or misleading statements created "an unrealistically positive assessment of ShengdaTech" in the market, and this "fraudulently created" both a market for and an overvaluing of the notes. Id. ¶¶ 22, 26, 32, 61-62, 247. They contend that the notes "would never have come into the market but for the fraud," or, if they had, would have done so with more favorable terms to investors, and that the Plaintiffs would not have purchased the notes at all or on the terms they did but for the misrepresentations of KPMG-HK and Morgan Stanley. Id. ¶ 247.
The Plaintiffs further allege that immediately following Shengda's March 2011 press release stating that KPMG-HK had encountered discrepancies in its 2010 audit, the Plaintiffs sought to sell their convertible bonds, but the market had become illiquid. Id. ¶¶ 248-250. As a result, having purchased the bonds at or near par, and in many cases above par value, the Plaintiffs "lost nearly their entire investment." Id. ¶¶ 25, 231, 248-250, 255.
This case came to this session, having been before two other judges in this district previously. The motion to dismiss now before me follows a familiar pattern for motion to dismiss practice in securities fraud litigation: successive motions to amend the pleadings creating a moving target for an extended period of time until the plaintiffs' allegations come to rest and can be examined by the court.
Miller filed its complaint on December 1, 2011, alleging one count of violation of the Massachusetts Uniform Securities Act, Mass. Gen. Laws. ch. 110A, § 410, against Morgan Stanley and one count of negligent misrepresentation under state common law against KPMG-HK. Compl. ¶¶ 1-3, 143-157. Morgan Stanley filed a motion to dismiss the original complaint on January 31, 2012 for failure to state a claim. This was denied by Judge Tauro. See Miller Inv. Trust v. Morgan Stanley & Co. Inc., 879 F.Supp.2d 158 (D. Mass. 2012).
Miller filed its first Amended Complaint on August 29, 2012, preserving the original two counts and adding a third count for violation of § 18 of the Exchange Act by KPMG-HK.
Thereafter, in July 2013, KPMG-HK filed a renewed motion to dismiss the Amended Complaint asserting inadequacy in the pleadings. Miller moved for leave to file a Second Amended Complaint, having provided notice of its intent to do so in November 2013 in light of factual discovery it was obtaining in another matter regarding the same underlying events. Simultaneously, Jura moved to intervene as a plaintiff pursuant to Fed. R. Civ. P. 24(b)(2) with respect to only count one against Morgan Stanley. Judge O'Toole granted both the motion for leave to amend and the motion to intervene, and dismissed KPMG-HK's pending motion to dismiss as moot in light of the anticipated Second Amended Complaint, permitting KPMG-HK to file a new motion to dismiss thereafter.
The Plaintiffs filed their Second Amended Complaint on March 10, 2014.
On January 15, 2015, the Plaintiffs filed yet another motion to amend the complaint and for leave to file additional allegations, which KPMG-HK opposed. After argument on both, I granted Miller's motion to amend and denied KPMG-HK's motion to dismiss without prejudice. Thereafter, Miller filed its Third Amended Complaint.
The claims relevant to the instant motion — those brought by Miller against KPMG-HK — are that the statements in the 2008 and 2009 audit reports, regarding KPMG-HK's compliance with the PCAOB standards and Shengda's compliance with GAAP, constitute negligent misrepresentation and violate § 18 of the Exchange Act, and further that the statement in KPMGHK's comfort letter that Shengda's 2010 quarterly financial statements conformed with GAAP also constitutes negligent misrepresentation. TAC ¶¶ 268, 272, 277, 278.
In order to survive a motion to dismiss pursuant to Fed. R. Civ. P. 12(b)(6), "a complaint must contain sufficient factual matter, accepted as true, to state a claim to relief that is plausible on its face." Ashcroft v. Iqbal, 556 U.S. 662, 678, 129 S.Ct. 1937, 173 L.Ed.2d 868 (2009) (internal quotation marks and citation omitted). Dismissal for failure to state a claim is appropriate when the pleadings set forth nothing more than "[t]hreadbare recitals of the elements of a cause of action, supported by mere conclusory statements." Id.; see Maldonado v. Fontanes, 568 F.3d 263, 268 (1st Cir. 2009); see also Menard v. CSX Transp., Inc., 698 F.3d 40, 45 (1st Cir. 2012).
The controlling pleading is the Plaintiffs' Third Amended Complaint. Although I am "generally limited to considering facts and documents that are part of or incorporated into the complaint," Giragosian v. Ryan, 547 F.3d 59, 65 (1st Cir. 2008) (citation and internal quotation marks omitted), I may also consider documents to which "a complaint's factual allegations are expressly linked." Beddall v. State St. Bank & Trust Co., 137 F.3d 12, 17 (1st Cir. 1998); see In re Citigroup, Inc., 535 F.3d 45, 52 (1st Cir. 2008). Here, I will consider the audit reports prepared by KPMG-HK for fiscal years 2008 and 2009, including the 2008 internal control audit report; the comfort letter issued by KPMG-HK in December 2010; the 2011 press releases, which have been provided by the Plaintiff; and relevant SEC filings to the extent they have been incorporated into the Third Amended Complaint and provided by the parties.
Federal Rule of Civil Procedure 8(a)(2) requires that a complaint provide "a short and plain statement of the claim showing that the pleader is entitled to relief." Claims under § 18 of the Exchange Act are subject to the heightened "clarity and basis" pleading requirement of the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. § 78u-4. See generally In re Stone & Webster, Inc., Sec. Litig., 414 F.3d 187, 195, (1st. Cir. 2005) ("The clarity-and-basis requirement of the PSLRA ... seem to apply equally to
Since the passage of the PSLRA, the First Circuit has observed that the PSLRA pleading standards are "congruent and consistent" with its own prior interpretation of Federal Rule of Civil Procedure 9(b), and that both essentially impose the same requirements. Greebel v. FTP Software, Inc., 194 F.3d 185, 193-94 (1st Cir. 1999); see In re Stone & Webster, Inc., 414 F.3d at 195, 199. Consistent with Greebel, other judges in this district have concluded that Rule 9(b) applies to § 18 claims. See Lindner Dividend Fund, Inc. v. Ernst & Young, 880 F.Supp. 49, 57 (D. Mass. 1995) (collecting cases and finding Rule 9(b) applicable to § 18 claims).
To make a claim under § 18(a), Miller must plead that "(i) the defendant made a [materially] false or misleading statement, (ii) the statement was contained in a document `filed' pursuant to the Exchange Act or any rule or regulation thereunder, (iii) reliance on the false statement, and (iv) resulting loss to [Miller]." In re Stone & Webster, Inc., 414 F.3d at 193; see 15 U.S.C. § 78r; Special Situations Fund, 775 F.Supp.2d at 245. Proof of scienter is not required. In re Stone & Webster, Inc., 414 F.3d at 193, 202.
Miller has identified three specific SEC filings in which it contends that KPMGHK made false statements: (a) the 2008 audit report accompanying Shengda's 2008 Form 10-K, (b) the 2008 internal control audit report accompanying Shengda's 2008 Form 10-K, and (c) the 2009 audit report accompanying Shengda's 2009 Form 10-K.
What is required to plead and prove falsity under federal securities laws depends on whether the statement at issue is one of fact or opinion. The Supreme Court clarified the distinction between these types of statements and when they may be actionable for their falsity in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, ___ U.S. ___, 135 S.Ct. 1318, 191 L.Ed.2d 253 (2015).
In Omnicare, the Supreme Court reasoned that:
However, statements of opinion may be actionable when the fact affirmed by the statement of opinion, namely "that the speaker actually holds the stated belief," is untrue. Id. at 1326. A statement of opinion accordingly may be the basis for § 11 liability if the stated belief is both inaccurate (i.e., not true) and not held by the speaker. See id. at 1326 & n.2 (adopting reasoning of Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1096, 111 S.Ct. 2749, 115 L.Ed.2d 929 (1991), that "inadvertently correct assessment" relieves speaker of liability). In addition, a statement of opinion that contains any "embedded statements of fact" is actionable if the supporting fact itself is untrue, because the statement "affirm[s] not only the speaker's state of mind ... but also an underlying fact." Id. at 1327.
The Omnicare Court also explained that under the separate material omissions clause of § 11, a pure statement of opinion may be actionable if the "statement omits material facts about the issuer's inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself." Id. at 1329. Liability thus "may result from omission of facts — for example, the fact that the speaker failed to conduct any investigation — that rebut the recipient's predictable inference." Id. at 1330.
Omnicare's framework for claims arising under § 18 has been deployed in the lower courts. See, e.g., Special Situations Fund III QP, L.P. v. Deloitte Touche Tohmatsu CPA, Ltd., 96 F.Supp.3d 325, 347 (S.D.N.Y. 2015) (citing Omnicare, 135 S.Ct. at 1327), aff'd, 645 Fed.Appx. 72 (2d Cir. 2016), cert. denied, ___ U.S. ___, 137 S.Ct. 186, 196 L.Ed.2d 126 (2016). The Supreme Court's parsing of statements in Omnicare is consistent with much of the prior case law for claims of false statements under § 11 and § 18, albeit permitting a slightly more expansive reach. See, e.g., In re Merck & Co., Inc. Sec., Derivative & "ERISA" Litig., Civ. Action Nos. 05-1151(SRC), 05-2367(SRC), MDL No. 1658(SRC), 2015 WL 2250472, at *21 (D.N.J. May. 13, 2015) (Omnicare is consistent
Existing precedent, read in light of Omnicare, illustrates the following pleading requirements for a material misstatement or omission under § 18. For a statement of fact, the plaintiff need only plead that the statement itself is untrue or lacked a reasonable basis (i.e., objective falsity). See Fait v. Regions Fin. Corp., 655 F.3d 105, 110 (2d Cir. 2011). If the allegation is the omission of a material fact, the plaintiff must plead that "disclosure of [the omitted] information is `necessary to make ... [the] statements made, in the light of the circumstances under which they were made, not misleading.'" In re Sanofi Sec. Litig., 87 F.Supp.3d 510, 527 (S.D.N.Y. 2015) (quoting Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44, 131 S.Ct. 1309, 179 L.Ed.2d 398 (2011) (internal quotation marks and citation omitted)).
For a statement of opinion, the plaintiff must plead that the statement falsely represented the speaker's belief at the time it was made (i.e., that the speaker did not sincerely believe the statement) and that it was untrue; that a statement of fact embedded within the opinion is untrue; or that the speaker omitted material facts that would make the statement misleading to a reasonable investor. See Omnicare, 135 S.Ct. at 1325-27, 1329-30; Plumbers' Union Local No. 12 Pension Fund v. Nomura Asset Acceptance Corp., 632 F.3d 762, 775 (1st Cir. 2011); see also Corban v. Sarepta Therapeutics, Inc., No. 14-cv-10201-IT, 2015 WL 1505693, at *6 (D. Mass. Mar. 31, 2015); In re BioScrip, 95 F.Supp.3d at 728-29; In re Sanofi, 87 F.Supp.3d at 527-28. An adequate pleading of falsity for an opinion therefore requires subjective falsity only in the absence of allegations that an embedded statement of fact was untrue at the time or that there was a material omission in the opinion. See Omnicare, 135 S.Ct. at 1326 & n.2; Plumbers' Union, 632 F.3d at 775; In re Credit Suisse First Bos. Corp., 431 F.3d 36, 47 (1st Cir. 2005), overruled on other grounds by Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007); see also Fait, 655 F.3d at 110.
Miller first challenges as false KPMG-HK's statements, in its 2008 and 2009 audit reports and in its 2008 internal control audit report, that it "conducted [its] audit[s] in accordance with the standards of the [PCAOB] (United States)." TAC ¶¶ 59-61(a), (c), 108-208; 2008 Report; 2008 Internal Control Report; 2009 Report. The PCAOB, created by the Sarbanes Oxley Act of 2002, establishes and maintains standards that auditors must follow in auditing U.S. public companies. See Free Enter. Fund v. Pub. Co. Accounting Oversight Bd., 561 U.S. 477, 484-85, 130 S.Ct. 3138, 177 L.Ed.2d 706 (2010). Among these standards are "generally accepted auditing standards" ("GAAS"), codified as AU § 150 in the PCAOB standards.
The parties dispute whether KPMGHK's statement of compliance is one of fact or opinion. Many courts, following a decision by Judge Kaplan in the Southern District of New York, have concluded that statements regarding GAAS compliance in an audit report are opinions.
Several other courts have implied that they would be open to considering a statement of PCAOB/GAAS compliance to be a statement of fact. See, e.g., Deephaven Private Placement Trading, Ltd. v. Grant Thornton & Co., 454 F.3d 1168, 1175-76 (10th Cir. 2006); Edward J. Goodman Life Income Trust v. Jabil Circuit, Inc., 595 F.Supp.2d 1253, 1282 (M.D. Fla. 2009), aff'd, 594 F.3d 783 (11th Cir. 2010); see also MHC Mut. Conversion Fund, L.P. v. Sandler O'Neill & Partners, L.P., 761 F.3d 1109, 1117 n.6 (10th Cir. 2014) (clarifying that Deephaven did not hold whether statement was one of fact or opinion).
In the wake of Omnicare, I have come to agree with Judge Pechman that statements by auditors of their own compliance with the PCAOB standards or GAAS are statements of fact. See In re Wash. Mut., 694 F. Supp. 2d at 1224. Because the auditor itself is the one tasked with complying with the standards, the statement that an auditor has so complied in conducting its audit is best understood as one of fact. Compare In re Credit Suisse, 431 F.3d at 47 (analysts' stock ratings are "best understood as statements of opinion, not as unadulterated statements of objective fact," because "they rest upon outsiders' views about a corporation rather than upon a corporate insider's factual assertions regarding his or her own company"). There is no reason that an auditor cannot state with certainty that it followed the PCAOB standards and the GAAS therein as it understood them, including that it exercised the independent judgment that is required by those standards. Cf. Omnicare, 135 S.Ct. at 1325 (statement of fact is expression of "certainty about a thing").
Because a statement of compliance with the PCAOB standards is one of fact, Miller need only show, through well-pleaded allegations satisfying the heightened standards of the PSLRA and Rule 9(b), that KPMG-HK failed to perform its audits in compliance with the PCAOB standards.
Miller identifies numerous GAAS and other PCAOB requirements that it alleges KPMG-HK knowingly failed to satisfy. The largest collection of such allegations involves KPMG-HK's conduct following its discovery of a misrepresentation by management regarding a related party.
In August 2007, Shengda's Chief Financial Officer, Anhui Guo, reported to Shengda's previous auditor, Hansen, and to Shengda's board that Shengda had sold its interest in Shandong Shengda Chemical Machinery Co. Ltd. ("SSCM") in an arm's length transaction to Prosper Crown Limited, and that SSCM was no longer a related party. TAC ¶¶ 40, 112-114. This was inaccurate, because Shengda's CEO, Xiangzhi Chen ("X. Chen"), continued to serve as the CEO of SSCM, making it a related party requiring disclosure. TAC ¶¶ 41, 112-113, 120. Hansen expressed skepticism over Guo's representation and investigated further, but Guo falsely affirmed by email to Hansen on February 18, 2008, that there was no relationship between SSCM and any parties related to Shengda. Id. ¶¶ 115-118. Guo made the same representations to Shengda's Audit Committee throughout the year. Id. ¶¶ 120-124. As a result, the Audit Committee did not review transactions with SSCM for approval under its related-party transaction policy. Id. ¶ 125. King & Shine Partners, Ltd., a law firm that conducted due
Miller alleges that when KPMG-HK became Shengda's auditor, it inquired about related parties and, like those inquiring before it, did not receive an indication from management that SSCM was a related party after July 2007. TAC ¶ 126. But on February 14, 2009, Michael Tse, a KPMG-HK auditor, learned from A. Carl Mudd, the chair of Shengda's Audit Committee, that X. Chen continued to be SSCM's CEO. Id. ¶¶ 127, 130. In addition, KPMG-HK knew that Prosper Crown had paid only $9.3 million for SSCM, despite SSCM's 2007 revenues of $45 million. Id. ¶ 137. Both of these facts suggested that the sale to Prosper Crown was not an arm's length transaction, and that SSCM remained a related party.
Miller alleges that what KPMG-HK did upon its discovery that Guo had misrepresented SSCM's status, and that SSCM remained a related party, did not comply with the PCAOB standards in several respects.
First, Miller alleges that KPMG-HK did not adequately confirm the precise nature of the relationship between SSCM and Shengda through extrinsic evidence. TAC ¶¶ 134, 150-152. Because KPMG-HK knew that SSCM was a related party, it was required under the PCAOB standards to obtain assurances from the board that the related-party transaction was approved; to obtain information about the related party and other significant information from intermediaries, other agencies, and the prior auditor; and to confirm the transactions between Shengda and SSCM, among other responsibilities. AU §§ 315.09, 334.08-.10; see AS No. 18. TAC ¶¶ 130, 150-151. Miller identifies two specific sources that it contends KPMG-HK should have consulted but did not: Prosper Crown's public corporate records filed in Hong Kong and available on the internet at a cost, and SSCM's AIC filings. Id. ¶¶ 134, 151(a), (d). These sources would have revealed that a Shengda executive, Pu Li, was Prosper Crown's sole director, and its general manager was Zhen Chen ("Z. Chen"), an individual whom Miller describes as "a protégé" of Shengda's CEO X. Chen. Id. ¶¶ 134, 151(a), (d). But these allegations are not sufficient to establish that KPMG-HK failed adequately to satisfy the directives of the PCAOB standards Miller cites. TAC ¶¶ 130, 150-151.
Additional allegations assert that KPMG-HK corresponded with Hansen, King & Shine, Mudd, Shengda management, and the Shengda board generally about the transactions between SSCM and Shengda. Id. ¶¶ 99-101, 128-134, 209. Miller's allegation that KPMG-HK would have learned something new from consulting the foreign document filings is belied by its allegation that the same names were disclosed in Guo's email to Hansen on February 18, 2008, in which Guo expressly represented that these individuals "have no relationship with ShengdaTech, Inc." Id. ¶¶ 118, 151(a). Miller does not specifically allege that the Hong Kong corporate records and AIC filings would have revealed the connections these individuals had to Shengda. Nor does Miller's additional allegation that KPMG-HK should have confirmed transactions with the banks that processed payments from Shengda to SSCM indicate what more that investigation would have provided to KPMG-HK on this issue. Id. ¶ 151(b). See Oaktree Capital Mgmt., L.P. v. KPMG (Oaktree I), 963 F.Supp.2d 1064, 1086-87 (D. Nev. 2013); Lindner Dividend Fund, 880 F.Supp. at 58.
Second, Miller alleges that KPMG-HK's discovery that SSCM remained a related party required it to investigate whether Guo's prior representations were lies — and illegal acts — or mere
Although determining whether an act is illegal is "normally beyond the auditor's professional competence," AU § 317.03, the auditor must make some attempt to determine the act's illegality. In detecting and reporting misstatements resulting from illegal acts relevant to financial statements, auditors are guided by both AU § 317 and AU § 110. The PCAOB standards suggest that an auditor read minutes, inquire of management and the client's legal counsel, examine supporting documents, and test the details of transactions and balances with third parties. AU §§ 317.08, .10, .11. If an auditor is unable to determine if an act is illegal, the auditor need only "consider the effect on his report," and may need to disclaim an opinion on the financial statements. AU §§ 317.19,.21. If the auditor has concluded that "an illegal act has a material effect on the financial statements" and has not been disclosed, the auditor should "express a qualified opinion or an adverse opinion on the financial statements taken as a whole, depending on the materiality of the effect on the financial statements," AU § 317.18, and should inform the Audit Committee and senior management. 15 U.S.C. § 78j-1(b)(1)(B). TAC ¶¶ 143-144.
Miller alleges that KPMG-HK's investigation into whether Guo's prior representations were intentionally or inadvertently false was inadequate under these standards. TAC ¶¶ 137, 145. In a March 23, 2009 memorandum summarizing its investigative efforts, KPMG-HK indicated that it had corresponded with Hansen and King & Shine regarding their knowledge and asked Shengda's management to represent that SSCM was not a related party; however, KPMG-HK did not indicate that it asked specifically whether Guo had lied to any of them.
In addition, although Miller alleges that KPMG-HK did not consult third-party records to confirm transactions, Miller does allege that KPMG-HK consulted many of the sources suggested by the PCAOB standards, including legal counsel and the prior auditor. See AU §§ 317.08-.11. These source lists are merely suggestions; an exhaustive exploration of them is not required by the standards. See, e.g.,
Miller further alleges that, following its investigation, KPMG-HK neither brought the possibility that Guo had lied to the attention of the Audit Committee, as evidenced by board meeting minutes and the attestation of two Shengda board members, nor disclaimed an opinion on Shengda's 2008 financial statements. TAC ¶¶ 135, 145. Both of these allegations are belied by other allegations in the Third Amended Complaint. Mudd, the chair of the Audit Committee, had a conversation with KPMG-HK demonstrating that he knew he had incorrectly understood SSCM no longer to be a related party because of earlier misrepresentations by Guo. TAC ¶ 130. The PCAOB standards and federal securities laws require only that the auditor "assure himself that the audit committee is adequately informed as soon as practicable and prior to the issuance of the auditor's report." AU § 317.17; see 15 U.S.C. § 78j-1(b)(1)(B). Surely the Audit Committee, with this knowledge, could infer that Guo's representations regarding SSCM were inaccurate and could respond accordingly. KPMG-HK also communicated directly with Guo after its discovery of the error, informing Guo that Shengda's "failure to disclose related-party transactions meant that its financial statements contained material errors" and discussing how to proceed appropriately with 2008 reporting. TAC ¶ 100. Both of these interactions occurred prior to the issuance of KPMG-HK's 2009 audit report.
For the same reasons, Miller's allegations regarding KPMG-HK's obligation to convince Shengda to restate its 2007 financials fail.
In sum, although Miller has made "specific allegations about the steps an auditor took, the way in which it planned its audit, and the procedures it employed," Oaktree I, 963 F.Supp.2d at 1086, it has not demonstrated that these steps and procedures were non-compliant with the PCAOB standards requiring investigation of a potential illegal act, disclosure of a prior material misstatement, skepticism of representations by management, and disclosure of related-party transactions.
Miller next alleges that KPMG-HK's acknowledgment of material weaknesses in Shengda's internal controls in its 2008 internal control audit report did not satisfy the PCAOB standards. Under AS No. 5.91, "[w]hen expressing an adverse opinion on internal control over financial reporting because of a material weakness, the auditor's report must include ... [t]he definition of a material weakness ...[,] [a] statement that a material weakness has been identified and an identification of the material weakness described in management's assessment." TAC ¶ 210.
In its 2008 report, KPMG-HK stated that "[m]aterial weaknesses have been identified and included in management's assessment related to the lack of adequate policies, procedures and personnel to address the accounting for and disclosures of non-routine transactions and the Company's internal control over the accounting for income taxes.
Miller alleges that KPMG-HK did not specifically identify as a material weakness "critical failure[s]" regarding disclosure of related-party transactions with SSCM, and instead disclosed "much more innocuous failures." TAC ¶¶ 61(c), 211-212. KPMG-HK, for its part, contends that "accounting for and disclosures of non-routine transactions" encompasses related-party transactions; Miller responds that Shengda's transactions with SSCM were in fact routine.
Drawing all reasonable inferences from the allegations in Miller's favor, I find Miller has adequately pled that KPMG-HK's internal control audit report omitted a material weakness that was known to it at the time, and that required specific disclosure under AS No. 5.91.
The Third Amended Complaint identifies particular facts that tie a discrete auditing requirement to information known to KPMG-HK at the time. Compare In re BioScrip, 95 F.Supp.3d at 726-27 (statements suggesting that defendant "routinely responded to investigatory requests from the Government, but was not presently in the process of responding to such a request," was misleading, "because the inference is available that a reasonable investor could have read them to mean that [defendant] was not already in receipt of just such a request for information"). Edward J. Goodman, 595 F.Supp.2d at 1282. A reasonable investor would expect that inadequate related-party transaction disclosures would be identified as a material weakness in this context, and therefore the absence of this identification is actionable as a material omission. See Omnicare, 135 S.Ct. at 1330, 1332.
Miller next alleges that KPMGHK performed an inadequate confirmation process. Under the PCAOB standards, auditors may employ a confirmation process "to obtain evidence from third parties about financial statement assertions made by management" as one procedure in the audit risk assessment. AU § 330.06; see AU §§ 330.04-.09; see also AU § 150.02 (Standards of Field Work No. 3) ("Sufficient appropriate evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit."). When there is a greater "combined assessed level of inherent and control risk," the auditor generally needs greater assurances, which can be obtained through confirmation procedures. AU § 330.07. Contrary to Miller's assertion, the PCAOB standards do not require auditors to obtain independent confirmation of specific financial statement entries; rather, whether and to what extent to engage in a confirmation process is left to the discretion of the auditor based on its assessment of inherent and control risk. See AU §§ 330.05-.10. TAC ¶¶ 14(a), 153-154.
When an auditor chooses to perform a confirmation process, "the auditor should maintain control over the confirmation requests and responses" to minimize the chance of biased results due to interception or alteration. AU § 330.28. This entails "establishing direct communication between the intended recipient and the auditor." AU § 330.28. Further follow up, such as a phone call, to ensure the validity of a confirmation response is recommended by the PCAOB standards only when the response comes in a form other than a written communication mailed to the auditor. AU § 330.29.
Miller alleges that KPMG-HK did not comply with the PCAOB standards when it engaged in its confirmation process because it obtained the addresses for the
This is a classic "should have, had they, must have" allegation. See Oaktree I, 963 F.Supp.2d at 1086-87. Nothing in the PCAOB standards explicitly requires verifying confirmation addresses against public records or making on-site visits. As Judge Mahan observed, "[a]n auditor is not tasked with checking over every single document and making contact with every company that its client does business with...." Oaktree Capital Mgmt., L.P. v. KPMG (Oaktree II), No. 2:12-CV-956 JCM (GWF), 2014 WL 3816392, at *4 (D. Nev. Aug. 4, 2014), see supra note 12 for subsequent history of Oaktree II. Miller has not alleged that any of the confirmations were received by facsimile or orally, thereby triggering a need for confirmation of their validity; to the contrary, Miller alleges that the Shengda insiders mailed the completed confirmation forms back to KPMG-HK as instructed. TAC ¶¶ 154, 157; see AU § 330.29
In Oaktree I, Judge Mahan concluded that "[a] number of other explanations, including a failure by Shengda's internal accountants to detect management fraud, [or] a remarkably well-covered management fraud scheme, ... are equally or more likely to have resulted in the inaccurate financial reporting alleged by plaintiffs." Oaktree I, 963 F.Supp.2d at 1087. Miller's vague reference to an earlier "lie" by Shengda is not sufficiently specific to give rise to the conclusion that KPMG-HK should have distrusted all information coming from Shengda, or that it should have suspected that addresses supplied by Shengda for its banks, suppliers, and customers would be inaccurate. The only identifiable culprit in the misrepresentation of SSCM's related-party status is Guo, and Miller does not allege that it was Guo who provided the addresses to KPMG-HK. Indeed, Miller does not identify who at Shengda supplied the addresses. TAC ¶¶ 156-157.
In addition, although the auditing standards call for "a heightened degree of professional skepticism" in certain circumstances, such as when confirming "significant, unusual year-end transactions that have a material effect on the financial statements," AU § 330.27, Miller does not identify the timing of the confirmation process in relation to the SSCM discussions or any other allegedly fraudulent conduct at Shengda — including allegedly "vastly overstated" transactions — that could have formed a basis for such heightened skepticism.
Miller next identifies discrepancies in the documentation supporting Shengda's financial statements that it alleges KPMGHK should have observed while conducting its 2008 and 2009 audits. TAC ¶¶ 167-208. It contends that KPMG-HK's failure to notice or act on these "red flags" violated the PCAOB standards directing auditors to exercise due care and employ professional skepticism, to assess the nature of the audited business adequately, to obtain "[s]ufficient competent evidential matter... to afford a reasonable basis for an opinion," and to respond to signals of potential fraud. AU §§ 110, 150.02, 230.07, 316.86; see TAC ¶¶ 19, 167.
Miller alleges that KPMG-HK did not recognize deficiencies in the "chops" or seals that appeared on the confirmations sent back to KPMG-HK in 2008 and 2009 by two banks where Shengda allegedly held accounts. TAC ¶¶ 168-171. Miller alleges that "a facially deficient chop is as much a red flag in China as a signature claiming to be from a company's CEO but bearing the wrong name is in the U.S." However, Miller makes no allegations that KPMG-HK was required to check the chops against one another in subsequent years in order to perform a PCAOB-compliant audit, or that KPMG-HK would have possessed the requisite knowledge to understand why the chops of the identified banks were deficient at the time. Id. ¶¶ 15(b), 167-171. Furthermore, the PCAOB standards recognize that "[a]n audit conducted in accordance with GAAS rarely involves the authentication of such documentation, nor are auditors trained as or expected to be experts in such authentication." AU § 316.09.
To the extent Miller identifies other red flags that should have put KPMGHK on notice of Shengda's fraud — including Shengda's repeated accounting restatements, KPMG-HK's alleged urging of Shengda not to put certain things in writing, and the receipt of a warning of potential fraud from a third party
The vast majority of Miller's allegations of red flags fail for the simple reason that "an unseen red flag cannot be heeded." Stephenson v. PricewaterhouseCoopers, LLP, 768 F.Supp.2d 562, 573 (S.D.N.Y. 2011). The PCAOB standards explicitly contemplate that "a properly planned and performed audit may not detect a material misstatement resulting from fraud," and offer auditors direction in the reasonable steps they can take to attempt to detect such issues. AU § 316.12. Miller's allegations fail to demonstrate with specificity how KPMG-HK's missing these red flags at the time and under the circumstances violated the PCAOB standards. Cf. In re Stone & Webster, Inc., 414 F.3d at 214 (finding clarity-and-basis pleading standard not satisfied where complaint "lacks concreteness as to how the conduct of the audit related to the missed warning signs."); In re Cabletron Sys., 311 F.3d at 36.
Miller alleges that KPMG-HK made numerous discoveries between May and November 2010 that revealed that several of Shengda's purported customers were false or non-existent and that Shengda had been supplying KPMG-HK with forged checks and bills of customer transactions. TAC ¶¶ 192-208. Miller also alleges that KPMG-HK discovered additional information about SSCM's related-party status during this time, and that it failed to act in accordance with the PCAOB standards in responding to this information. Id.
The PCAOB standards set forth procedures for an auditor to employ when it obtains material information it did not previously possess. AU § 561.04. If the auditor determines through further investigation that the information is reliable, that "the facts existed at the date of his report," and that the information is such that "action should be taken to prevent further reliance on his report," the PCAOB standards instruct auditors to advise their clients to make an appropriate disclosure, and if the client refuses, to do so itself. AU § 561.04-.08; see In re Cabletron Sys., Inc., 311 F.3d 11, 36 (1st Cir. 2002) (recognizing duty to correct). Such disclosure may include issuing revised financial statements and auditor's reports. AU § 561.06(a).
Although these standards, in light of KPMG-HK's discoveries in late 2010, may have required such action, they cannot serve to render KPMG-HK's earlier statements in March 2009 and March 2010 of compliance with the PCAOB standards false or misleading for purposes of § 18, which requires that the statement was false or misleading "at the time and in the light of the circumstances under which it was made." 15 U.S.C. § 78r(a); cf. In re Cabletron Sys., 311 F.3d at 36 (complaint must demonstrate that eventual problems were known to defendants at time statements were made).
Finally, Miller alleges that the ease with which KPMG-HK eventually uncovered such a large fraud shows a failure to comply with PCAOB standards. Miller contends that KPMG-HK's own behaviors illustrate how central these above-described investigative actions are to discovering fraud and why they should have been undertaken during the annual audits. KPMG-HK performed many of these investigative actions in March 2011 — at which point it learned of the significant issues in Shengda's financial statements — and used these sources as evidence of Shengda's fraudulent activity.
In some cases, particularly where scienter is at issue, the size of the fraud can "strongly suggest[]" that an audit did not comply with the PCAOB standards. See McIntire v. China MediaExpress Holdings, Inc., 927 F.Supp.2d 105, 134 (S.D.N.Y. 2013); cf. In re MicroStrategy, Inc. Sec. Litig., 115 F.Supp.2d 620, 652 (E.D. Va. 2000) (auditor's ability to identify and correct violations for two years of contracts in two weeks supported inference of scienter stemming from magnitude of restatement and simplicity of GAAP principles violated). But see In re Longtop Fin. Techs. Ltd. Sec. Litig., 910 F.Supp.2d 561, 578 (S.D.N.Y. 2012) (in context of proving scienter, "fraud's large size, standing alone, is insufficient to show recklessness," as is "rapidity with which [the] fraud unraveled").
Here, these considerations are not sufficiently compelling to stand in as a proxy for the particularized allegations needed to state a claim. To be sure, "[a]t the pleading stage, courts have recognized that allegations of GAAS violations, coupled with allegations that significant `red flags' were ignored, can suffice to withstand a motion to dismiss." In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 279 (3d Cir. 2006); see Greebel, 194 F.3d at 203-04. But as described above, the red flags identified in the Third Amended Complaint are neither actionable nor significant.
Miller's claim that KPMG-HK did not perform its audits in accordance with the PCAOB standards and GAAS rests primarily on "a litany of conclusory allegations of failure to conform to various GAAS standards," In re Stone & Webster, Inc., 414 F.3d at 214, suggesting only that KPMG-HK was duped throughout its performance of facially PCAOB-compliant audits. That KPMG-HK could have performed a more robust audit does not render the audit it did perform non-compliant. See In re Puda Coal, 30 F.Supp.3d at 259-60. In light of the information KPMG-HK had at the time and the relevant pleading standards, Miller's allegations can establish only that KPMG-HK's statement of compliance with the PCAOB standards in conducting its 2008 internal control audit was materially false or misleading because it did not disclose a known material weakness.
Miller also challenges as false the following statement that appeared in KPMG-HK's 2008 and 2009 audit reports:
TAC ¶¶ 59-61(b), ¶¶ 62-107; 2008 Report; 2009 Report.
Miller concedes that the statement of compliance with GAAP is a statement of
The GAAP themselves are broad, inherently subjective standards, as Judge Kaplan and the other judges following his opinion in In re Lehman Brothers characterize them; unlike the PCAOB standards and the GAAS therein, however, the GAAP are not rigorous codifications. See Buttonwood, 2012 WL 2086607, at *2; In re WorldCom, 352 F.Supp.2d at 478. GAAP "embody the prevailing principles, conventions, and procedures defined by the accounting industry from time to time." Young v. Lepone, 305 F.3d 1, 5 n.1 (1st Cir. 2002); see Shalala v. Guernsey Mem'l Hosp., 514 U.S. 87, 101, 115 S.Ct. 1232, 131 L.Ed.2d 106 (1995). The Supreme Court has observed that GAAP "are far from being a canonical set of rules," Thor Power Tool Co. v. Comm'r of Internal Revenue, 439 U.S. 522, 544, 99 S.Ct. 773, 58 L.Ed.2d 785 (1979), and are not compiled in "a single-source accounting rulebook." Shalala, 514 U.S. at 101, 115 S.Ct. 1232. Instead, there are "19 different GAAP sources," and an accountant must "consult an elaborate hierarchy of GAAP sources to determine which treatment to follow." Shalala, 514 U.S. at 101, 115 S.Ct. 1232. Because the GAAP are meant to embody contemporary conventions and procedures, "GAAP changes and, even at any one point, is often indeterminate." Id. This is in contrast to the PCAOB standards that, although requiring the exercise of discretion, can be identified from one source, and for which a statement of compliance is less a statement of belief than an assertion carrying some certainty. See In re WorldCom, 352 F.Supp.2d at 479.
More significantly, this statement does not affirm the auditor's own conduct, but rather expresses the auditor's opinion on the conduct of a third-party: the entity whose financial statements are being audited.
That an auditor's assurances of GAAP compliance in the audited statements is an opinion is clearly supported by the auditing standards themselves, and by the very objective of an audit "to express an opinion on the fairness, in all material respects, with which a company's financial statements present the financial position, results of operations, and cash flows of the company in conformity with GAAP." In re WorldCom, 352 F.Supp.2d at 479-80.
For this reason, many courts have classified GAAP compliance statements as opinions. See Deephaven, 454 F.3d at 1174-75; In re Colonial Bancgroup, 9 F.Supp.3d at 1265; Buttonwood, 2012 WL 2086607, at *2; Belmont Holdings Corp. v. SunTrust Banks, Inc., 896 F.Supp.2d 1210, 1229 n.17 (N.D. Ga. 2012); In re Lehman Bros., 799 F.Supp.2d at 303; Edward J. Goodman, 595 F.Supp.2d at 1282. This is also the position taken by Judge Mahan in the Oaktree litigation. See Oaktree II, 2014 WL 3816392, at *5; Oaktree I, 963 F.Supp.2d at 1090.
As a preliminary matter, I find Miller has adequately alleged with the specificity required by both the PSLRA and Rule 9(b) that the underlying assertion that Shengda's 2008 and 2009 financial statements fairly represented Shengda's financial position in conformity with GAAP was materially false.
To state a claim for § 18 liability, Miller must also plead with specificity either that KPMG-HK did not sincerely believe that Shengda's financial statements conformed with GAAP at the time it issued the audit reports, or that KPMG-HK omitted material facts that made the statement of compliance misleading to a reasonable investor in context. See Omnicare, 135 S.Ct. at 1329-30; Plumber's Union, 632 F.3d at 775. In other words, the claim hinges on what KPMG-HK knew when it offered its opinion on Shengda's GAAP compliance.
Miller first points to Shengda's frequent restatements to posit that KPMG-HK was on notice that Shengda was not keeping its books properly. TAC ¶¶ 206, 213-227. This proposition has been rejected by the First Circuit as a basis for alleging subjective falsity. See In re Credit Suisse, 431 F.3d at 49 ("[T]hat a speaker changes his or her mind and decides after the fact that an earlier opinion was ill-advised is insufficient to support an averment of subjective falsity.").
Miller's allegations that KPMGHK knew about Shengda's ongoing relationship with SSCM, which was not fully disclosed in Shengda's 2007 financial statements as required by GAAP, fail to establish subjective falsity for similar reasons. TAC ¶¶ 88-89, 92, 96-107, 208. As discussed above, the allegations show that KPMG-HK took steps in conjunction with Shengda to ensure that these related-party transactions were disclosed in the 2008 financial statements. TAC ¶¶ 100, 130, 209; id. ¶¶ 128-135, 145. Miller pleads that the 2008 Form 10-K did not disclose that Shengda had previously falsely stated that SSCM was not a related party; the pleadings also imply but do not explicitly allege that Shengda did not issue an additional corrective disclosure through a Form 8-K for its 2007 financial statements. Id. ¶¶ 100, 102, 106. However, Miller does allege that the 2007 issues were identified by KPMG-HK to Shengda's Audit Committee and its management. Id. ¶¶ 130, 209. A restatement of the 2007 financial statements as required by SFAS No. 154 ¶¶ 25-26 could be accomplished through disclosure in the 2008 Form 10-K or through an alternative disclosure; this determination was the responsibility of Shengda, perhaps in consultation with Hansen, its 2007 auditor.
Miller next asserts that KPMGHK's awareness that Shengda had poor internal controls over financial reporting, as indicated in its correspondence to the Audit Committee on March 31, 2009 and in its 2008 internal control audit report, should have alerted KPMG-HK to the likelihood that Shengda was committing fraud. AU §§ 316.07, .85 (internal control problems signal "an opportunity for a fraud to be perpetrated"). TAC ¶¶ 59, 183, 184, 209. But as discussed above, these allegations go to whether KPMG-HK's audit was sufficient under the PCAOB standards, and do not establish that KPMGHK had or should have had specific knowledge that Shengda's financial statements were not GAAP-compliant.
Miller's other allegations of KPMG-HK's knowledge of Shengda's purportedly blatant fraudulent accounting practices do not rise to the level of specificity required by the pleading standards. The allegations here are similar to those in In re Longtop:
In re Longtop, 910 F.Supp.2d at 581; see In re Puda Coal, 30 F.Supp.3d at 259-60. Miller has not pled that KPMG-HK knew enough at the time that it could not have believed its statement of GAAP compliance, or that KPMG-HK failed to take critical steps in its audit such that there is no reasonable basis on which it could have believed that Shengda's financial statements complied with GAAP at the time it opined that they did. As the First Circuit has acknowledged, "[s]imply pleading that the defendant knew of the falsity, without providing any factual basis for that knowledge, does not suffice." Ezra Charitable Trust v. Tyco Int'l, Ltd., 466 F.3d 1, 12-13 (1st Cir. 2006); see In re Cabletron, 311 F.3d at 34.
In order to survive a motion to dismiss on the one statement I have found actionable — KMPG-HK's statement of compliance with PCAOB standards in conducting its internal control audit — Miller must also adequately allege that its losses were caused by this false statement. See 15 U.S.C. § 78u-4(b)(4) (plaintiff bears burden of proving that act or omission "caused the loss for which the plaintiff seeks to recover damages" (codifying § 21D(b)(4) of the Exchange Act)). The First Circuit has declined to decide whether loss causation must meet the heightened pleading standard of Fed. R. Civ. P. 9(b) or merely the basic standard of Fed. R. Civ. P. 8(a). See Coyne v. Metabolix, Inc., 943 F.Supp.2d 259, 273 (D.Mass. 2013) (citing Mass. Ret. Sys. v. CVS Caremark Corp., 716 F.3d 229, 239 n.6 (1st Cir.
To establish loss causation, a plaintiff must show "a causal connection between the material misrepresentation and the loss." Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 342, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005). This means that the loss must be proximately caused "by a disclosure that reveals something about the fraudulent misstatement or omission." In re Credit Suisse-AOL Sec. Litig., 465 F.Supp.2d 34, 46-47 (D. Mass. 2006) (citing Lentell v. Merrill Lynch & Co., 396 F.3d 161, 173 (2d Cir. 2005)); In re Polaroid Corp. Sec. Litig., 134 F.Supp.2d 176, 188 (D. Mass. 2001). In other words, a plaintiff must "allege that it was the subject of the omission or fraudulent statement that caused the actual loss." In re Credit Suisse, 465 F.Supp.2d at 46 (citing Lentell, 396 F.3d at 173); see Dura Pharm., 544 U.S. at 344-45, 125 S.Ct. 1627.
As a threshold matter, Miller has adequately pled a loss. Miller purchased $8 million in bonds from what is now a bankrupt company that cannot satisfy Miller's claims in full. TAC ¶¶ 20-21, 25, 29, 32, 243-244, 252-254. These securities have no resale value. Id. ¶¶ 235-236, 248-250, 255. I find these pleadings satisfactory. However, Miller has not alleged a sufficient, specific causal connection between the loss and the subject of the otherwise actionable omission.
Miller primarily pursues a corrective disclosure theory, that is, that "a corrective disclosure ... led directly to a drop" in the value of the bonds. In re Evergreen Ultra Short Opportunities Fund Sec. Litig., 705 F.Supp.2d 86, 95 (D. Mass. 2010). To establish loss causation based on an inflated purchase price revealed by a disclosure, "the stock market must have reacted to the subsequent disclosure of the misconduct," Bricklayers & Trowel Trades Int'l Pension Fund v. Credit Suisse Secs. (USA) LLC, 752 F.3d 82, 86 (1st Cir. 2014), and not to a "tangle of [other] factors affecting price," such as "changed investor expectations, [or] new industry-specific or firm-specific facts, conditions, or other events." Dura Pharm., 544 U.S. at 343, 125 S.Ct. 1627. This "inflation-disclosure-deflation cycle" is a common scenario — but not the only one — in which loss causation may be established, provided the disclosure is sufficiently connected to the misstatement or omission. See Bricklayers, 752 F.3d at 86; In re Charles Schwab Corp. Sec. Litig., 257 F.R.D. 534, 547 (N.D. Cal. 2009) (citing Dura Pharm., 544 U.S. at 346, 125 S.Ct. 1627).
The corrective disclosure Miller identifies as the cause of its loss is the March 15, 2011 Shengda press release. Miller contends
The March press release, therefore, did not "reveal[] to the market the pertinent truth that was previously concealed or obscured by the company's fraud," Mass. Ret. Sys., 716 F.3d at 237 (citation omitted), that is, the undisclosed internal control issues, or "reveal[] to the market that defendants' [representations] were knowingly false." In re Credit Suisse, 465 F.Supp.2d at 45. Nor did it necessarily reveal that Shengda's financial status was not as robust as it had represented. Cf. Mass. Ret. Sys., 716 F.3d at 240 (although corrective disclosure need not contain "a direct admission that a previous statement is untrue," there must be some shared subject matter between disclosure and misrepresentation such that disclosure "as a whole, plausibly revealed [problems] to the market"). The press release simply did not "connect the current, present, negative information to the earlier false or misleading statement." Coyne, 943 F.Supp.2d at 273. Contrary to Miller's suggestion otherwise, the March press release cannot be said even to have "partially disclosed what the alleged misrepresentations had concealed from the market." Omanoff v. Patrizio & Zhao LLC, No. 14-723, 2015 WL 1472566, at *6 (D.N.J. Mar. 31, 2015) (quoting In re Bradley Pharm., Inc. Sec. Litig., 421 F.Supp.2d 822, 829 (D.N.J. 2006)).
It was not until after the March disclosure that the specific concerns, and their relevance to earlier accounting periods — including discrepancies in bank balances, supplier transactions, VAT invoices, third-party sales and payments, and customer information — were made known through the filing of a Form 8-K in May 2011 and subsequent announcements by Shengda. TAC ¶¶ 236-238, 251-253. Miller therefore cannot succeed on a claim that it suffered a loss caused by the revelation to the public of the specific misrepresentation or omission, because it alleges that its loss occurred before that revelation. See In re Daou Sys., Inc., 411 F.3d 1006, 1026-27 (9th Cir. 2005); see also Urman v. Novelos Therapeutics, Inc., 867 F.Supp.2d 190, 197 (D. Mass. 2012) (lack of temporal relationship between change in stock price and public revelation of alleged misrepresentation can defeat loss causation); cf. In re Evergreen, 705 F.Supp.2d at 95 (allegations that "[w]hen the defendants' alleged misstatements were ultimately revealed, the [shares] declined in value, resulting in losses" were sufficient to demonstrate loss causation). In placing the loss before the identified disclosure, Miller has failed to "eliminat[e] other possible explanations for th[e] price drop." Mass. Ret. Sys., 716 F.3d at 238 (citation omitted).
In the alternative, Miller argues that the March disclosure was a materialization of a "zone of risk" that KPMG-HK's misrepresentation concealed. See Lentell, 396 F.3d at 173 ("a misstatement or omission is the `proximate cause' of an investment loss if the risk that caused the loss was within the zone of risk concealed by the misrepresentations and omissions alleged by a disappointed investor"); In re Am. Int'l Grp., Inc. 2008 Sec. Litig., 741 F.Supp.2d 511, 534 (S.D.N.Y. 2010). Under this theory, the loss alleged must "be caused by the materialization of the concealed risk." Lentell, 396 F.3d at 173.
Whether this "zone of risk" theory is recognized in the First Circuit is unresolved. See In re Credit Suisse, 465 F.Supp.2d at 47 & nn.13-14. But see Tutor Perini Corp. v. Banc of Am. Sec. LLC, No.
In re Parmalat Securities Litigation, 375 F.Supp.2d 278, 305-07 (S.D.N.Y. 2005), a case on which Miller relies, is distinguishable here. In that case, the auditor similarly issued reports certifying that the financial statements of Parmalat fairly presented its financial position as of December 31, 2001. Id. at 306-07. However, the plaintiffs alleged that these reports concealed "that Parmalat had massive undisclosed debt and was unable to service it" — this was the concealed risk that ultimately caused the plaintiffs' loss. Id. at 307. The parallels to the instant case end there. What happened next was a direct materialization of the risk: Parmalat suffered a liquidity crisis in December 2003 and could not pay the bonds as they came due. Id. The very risk that the auditor had concealed came to fruition. Trading in Parmalat securities was suspended in Italy, followed by a sharp drop in prices of Parmalat stock and bonds on other exchanges. Id. Although "the true extent [of] the fraud was not revealed to the public until February," this was "immaterial where, as here, the risk allegedly concealed by defendants materialized during that time and arguably caused the decline in shareholder and bondholder value." Id.
In contrast to In re Parmalat, the foreseeable risks theoretically concealed by KPMG-HK's allegedly false statement in its audit report — that Shengda would not have the resources to pay its debts — were not what materialized in the March 2011 disclosure. Rather, that disclosure articulated potential financial discrepancies, not inability to pay outstanding bonds, years before the notes Miller held were to come due. While the March disclosure may have been a contributor to the decline in value and Miller's loss, there is no identifiable connection between this report and the omission in KPMG-HK's 2008 internal control audit report.
Some but not all judges in this district have "clearly held that Rule 9(b) applies to claims of negligent misrepresentation" because the "same rule against pleadings on `information and belief' and the same policy against allowing `strike suits' apply to negligent misrepresentation claims as apply to outright claims of fraud." In re Stratus Comput., Inc. Sec. Litig., No. 89-2075-Z, 1992 WL 73555, at *6 (D. Mass. Mar. 27, 1992); see Advanced Card Sys., Inc. v. Hewlett-Packard Co., No. 1:04-CV-12295, 2005 WL 6433203, at *5 (D. Mass. Oct. 28, 2004); Lindner, 880 F.Supp. at 57. But see Fed. Home Loan Bank of Bos. v. Ally Fin., Inc., No. 11-10952-GAO, 2013 WL 5466631, at *1-2 (D. Mass. Sept. 30, 2013) (concluding that Rule 9(b) does not apply to negligent misrepresentation claims because they do not sound in fraud).
My own view, as expressed above, is that Rule 9(b) applies where the complaint and the claims overall sound in fraud, and that a claim of negligent misrepresentation in this context so sounds, even absent a scienter element. See Softub, Inc. v. Mundial, Inc., 53 F.Supp.3d 235, 256 (D. Mass. 2014); cf. N. Am. Catholic Educ. Programming Found., Inc. v. Cardinale, 567 F.3d 8, 15 (1st Cir. 2009). Accordingly, I will apply Rule 9(b) in assessing the pleadings.
Under Massachusetts common law,
The statements at issue here are the same as those at issue in the § 18
KPMG-HK asserts that claims of negligent misrepresentation under state common law must meet the same falsity standards as § 18 claims, and that Miller has failed to plead with particularity that KPMG-HK's audit opinions were false. Miller does not dispute this proposition but instead contends, as above, that KPMGHK is incorrect in characterizing audit reports as statements of opinion rather than fact.
Although not precisely aligned, there are sufficient similarities between the falsity standards for negligent misrepresentation and § 18 to warrant equivalent analyses. Under Massachusetts case law, statements of opinion cannot give rise to a negligent misrepresentation claim. Softub, 53 F.Supp.3d at 255 (citing Zimmerman v. Kent, 31 Mass.App.Ct. 72, 575 N.E.2d 70, 75 (1991)); see Cummings v. HPG Int'l, Inc., 244 F.3d 16, 21 (1st Cir. 2001) (citing Logan Equip. Corp. v. Simon Aerials, Inc., 736 F.Supp. 1188, 1199 (D. Mass. 1990)); Commonwealth v. Quinn, 222 Mass. 504, 111 N.E. 405, 408 (1916).
Massachusetts courts look to the Restatement (Second) of Torts to determine whether a statement is one of opinion:
Cummings, 244 F.3d at 22 (quoting McEneaney v. Chestnut Hill Realty Corp., 38 Mass.App.Ct. 573, 650 N.E.2d 93, 96 (1995)). A defendant's knowledge of the accuracy of the statement is not determinative of whether the statement is one of opinion, because negligent misrepresentation "does not require a showing that the defendant even knew that the statements made were false or that the defendant actually intended to deceive the plaintiff." Marram, 809 N.E.2d at 1031 n.25 (quoting
This framework appears to parallel closely that in which a statement of opinion may be actionable under federal securities laws following Omnicare. Cf. Corban, 2015 WL 1505693, at *6 (statements of opinion are not actionable under federal securities laws unless plaintiffs allege that (1) opinions were objectively and subjectively false, "(2) self-embedded facts within the opinion are untrue, or (3) `material facts about the [opinion holder's] inquiry into or knowledge concerning a statement of opinion' were omitted" (quoting Omnicare, 135 S.Ct. at 1329)). Nonetheless, there is some indication of a potential divergence. For example, a judge of the Massachusetts Superior Court concluded that statements of compliance with GAAS or GAAP were statements of fact because the speaker held itself out as "having a level of expertise with respect to both GAAS and GAAP that the [listener] could not be expected to have." Bank of Am., N.A. v. BDO Seidman, LLP, 29 Mass. L. Rptr. 513, 2012 WL 806007, at *36 (Mass. Super. Ct. 2012). In Bank of America, Judge Fabricant acknowledged that federal case law classifies such statements as opinions, but reasoned that classifications should be made based on "specific claims in specific circumstances," taking into account "the departures from GAAS" that are alleged. Id. at *36 n.74; see Bily v. Arthur Young & Co., 3 Cal.4th 370, 407-08, 834 P.2d 745, 11 Cal.Rptr.2d 51 (Cal. 1992) (employing similar reasoning). This is a meaningful departure from the framework employed under § 18.
If the falsity standard for negligent misrepresentation is indeed aligned with the standard employed under § 18, my findings that Miller has not adequately pled falsity — but for the statement of PCAOB compliance in the 2008 internal control audit — stand as set forth above in my discussion of the § 18 claim. If, in contrast, the contours of falsity for negligent misrepresentation are different, I need not resolve whether Miller's pleadings are satisfactory, because I conclude that Miller has not adequately pled justifiable reliance.
KPMG-HK contends that Miller cannot establish that it owed a duty to Miller — and therefore that Miller justifiably relied on KPMG-HK's audit reports — because KPMG-HK did not supply the audit reports "for a transaction that [it] actually intend[ed] to influence." N. Am. Specialty Ins. Co. v. Lapalme, 258 F.3d 35, 41-42 (1st Cir. 2001). A plaintiff must establish that the auditor "knew (or intended) that the plaintiff, or any limited group of which the plaintiff was a member, would rely on the audit report in connection with an investment in [the company whose financial statements were the subject of the audit report]." Nycal, 688 N.E.2d at 1373. Massachusetts case law
In Nycal, 688 N.E.2d at 1369, 1373, a case involving a plaintiff's alleged reliance on an auditor's report in purchasing stock in a company that later declared bankruptcy and rendered the plaintiff's investment worthless, the Supreme Judicial Court affirmed that the plaintiff had not demonstrated justifiable reliance, because the defendant had not "prepare[d] the audit report for the plaintiff's benefit." Additionally, the Supreme Judicial Court reasoned:
Id. Similarly, in Cumis Insurance Society, Inc. v. BJ's Wholesale Club, Inc., 455 Mass. 458,918 N.E.2d 36, 50 n.26 (2009), the Supreme Judicial Court noted that the plaintiffs would not be able to establish the necessary "foreseeable reliance" where the defendants had "had no direct communication or connection with any of the 16,000 Visa issuers or the 20,0000 MasterCard issuers, and had no knowledge that any particular issuer was relying on any particular provision in the confidential merchant agreements."
Similarly here, there was no direct relationship between Miller and KPMG-HK. Rather, KPMG-HK had an agreement with Shengda to conduct audits of its financial statements. Miller has not alleged that KPMG-HK prepared these audit reports for any purpose other than inclusion by Shengda in its annual Form 10-K filings with the SEC. Absent more, this lack of privity would be enough to preclude Miller's negligent misrepresentation claim. See Nycal, 688 N.E.2d at 1373-74 (noting that in conducting annual audit and issuing resulting opinion, auditor "generally undertakes no duty to third parties" when unaware of any particular purpose for audit, and concluding that accountants are not required "to ensure the commercial decisions of nonclients where ... [they] did not know that their work product would be relied on by [a] plaintiff in making its investment decision").
Miller does allege that KPMG-HK gave permission to Morgan Stanley to include these audit reports in the PPM that Morgan Stanley distributed to potential Shengda bond purchasers in a private placement. Arguably, this creates a potential hook for reliance by permitting the inference that KPMG-HK was aware that its audit reports might be relied upon by investors. But there are two infirmities here. First, KPMG-HK gave Morgan Stanley permission to include its audit reports in the PPM after they were prepared. See Nycal, 688 N.E.2d at 1372 (auditor's knowledge measured at time audit report is published). Miller has not alleged that KPMG-HK had any knowledge prior to issuing its opinions that they would be used for this purpose. See id.; see also Fed. Home Loan, 2013 WL 5466631, at *6 (plaintiff must plead that auditor had "actual knowledge of the particular financial transaction that such information [was] designed to influence"
For the reasons set forth above, I GRANT Defendant KPMG-HK's motion to dismiss for failure to state a claim, Dkt. No. 169.
Although Hansen filed a motion to dismiss in April 2013, which typically would stay discovery under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. § 78u-4(b)(3)(B), Judge Schofield concluded that the stay did not apply to Hansen because it was subject only to a state negligent misrepresentation claim, and ordered discovery to proceed. Id. (May 21, 2013, ECF No. 39). Thereafter, Judge Schofield granted Hansen's motion to dismiss for lack of personal jurisdiction. Id. (June 21, 2013, ECF No. 40). Discovery then continued as to the defendants subject to federal securities law claims. The parties reached a settlement agreement prior to the completion of expert discovery, and the action was dismissed without prejudice on October 22, 2014. Id. (Oct. 22, 2014, ECF No. 110, 111). It is from the discovery completed in the Chen case that the Plaintiffs here drew additional allegations for their Second and Third Amended Complaints.
Another lawsuit filed in June 2012 also bears noting. Other investment managers and funds that had purchased bonds in the 2008 and 2010 Shengda offerings brought suit in the District of Nevada against Morgan Stanley, KPMG-HK, other KPMG entities, and Hansen, alleging "that KPMG HK and Hansen failed to follow generally accepted accounting standards ("GAAS") in their audits of Shengda's financials, falsely stated that Shengda's financial statements complied with [GAAP]; and falsely opined that Shengda's `internal controls' were sufficient." Oaktree Capital Mgmt., L.P. v. KPMG (Oaktree I), 963 F.Supp.2d 1064, 1071-72 (D. Nev. 2013). The Plaintiffs also alleged that KPMG-HK consented to the inclusion of these false statements in SEC filings. Id. at 1072. Accordingly, the Plaintiffs alleged violation of § 18 of the Exchange Act and negligent misrepresentation under state common law by KPMG-HK.
On KPMG-HK's motion to dismiss, Judge Mahan concluded that the Plaintiffs had failed to state a claim under § 18 as to the statements of GAAS and GAAP compliance, because the Plaintiffs did not allege objective falsity sufficiently. Id. at 1085-86, 1090-91. Judge Mahan accordingly granted KPMGHK's motion to dismiss, declining to exercise supplemental jurisdiction over the remaining state law claims. Id. at 1091, 1092.
In a later ruling, Judge Mahan granted Hansen's motion to dismiss as well. See Oaktree Capital Mgmt., L.P. v. KPMG Oaktree II, No. 2:12-CV-956 JCM (GWF), 2014 WL 3816392, at *5 (D. Nev. Aug. 4, 2014). The Plaintiffs appealed that decision to the Ninth Circuit, but the matter has since settled. See id., appeal docketed sub nom. Oaktree Capital Mgmt., L.P. v. Hansen, Barnett & Maxwell, P.C., No. 14-16632 (9th Cir. Aug. 25, 2014); see also id. (9th Cir. Mar. 13, 2015, ECF No. 25); id. (9th Cir. Dec. 10, 2014, ECF No. 14).
Nevertheless, I do note that other pleading requirements imposed by the PSLRA regarding the required state of mind (i.e., the "strong inference requirement") do not apply here, because § 18 lacks a scienter requirement. See In re Stone & Webster, Inc., 414 F.3d at 195-96; see also 15 U.S.C. § 78u-4(b)(2).
In conducting its audit, KPMG-HK created two separate audit teams, one responsible for auditing Shengda's operations in the Shandong province, and one responsible for auditing Shengda's operations in the Shaanxi province. TAC ¶ 172. The audit teams sent envelopes to the confirmation addressees that included response envelopes directed to the specific team. Id. ¶¶ 173-174. Miller alleges that "ShengdaTech caused purported Shandong addressees to respond to KPMG in envelopes addressed to KPMG's Shanxi team, and vice versa," which clearly signaled fraudulent conduct. Id. ¶¶ 175-176.
Also during its audit of the 2010 financials, KPMG-HK selected six fapiao — certificates of payment or receipt — to test and verify through a VAT invoice verification system operated by one of the provinces in which Shengda did business. Id. ¶¶ 177-182. In so doing, KPMG-HK discovered that all of them were forged. Id. ¶ 182, 227(c).
Miller also suggests that KPMG-HK should have consulted Shengda's AIC filings to verify another red flag, an alleged tip from someone concerning the implausible demand for Shengda's products. These allegations are barely pleaded and fail for the same reasons. TAC ¶¶ 15(c), 62-65, 191; see In re Puda Coal, 30 F.Supp.3d at 259; Perry, 2013 WL 4505199, at *5.
The PCAOB standard Miller alleges that KPMG-HK violated in not further pursuing this tip is the same it identifies in relation to KPMG-HK's failure to investigate the unusually high confirmation rate. TAC ¶¶ 15(a), 162-166, 190. That auditing standard was not introduced to the PCAOB standards until after KPMG-HK filed its last actionable document in March 2010. See supra note 34.
Even assuming that the PCAOB standards required follow-up investigation, Miller has not satisfied the clarity and basis requirement for this allegation. Miller implies but does not specifically allege that KPMG-HK did not investigate this warning. Miller's allegations regarding KPMG-HK's general auditing practices do not establish whether KPMG-HK followed them in its Shengda audits. TAC ¶¶ 18, 159, 190. Miller also does not identify the source of the tip, how KPMG-HK received it, or whether the statement in the tip was true. Id. ¶ 190.
In an attempt to salvage its § 18 claim, Miller now claims — in argument, but not in its pleadings — that the actual loss was not felt until Shengda's announcement of default on the bonds on June 9, the suspension of trading on June 10 (at which point Miller surely could not sell the bonds), or Shengda's filing for bankruptcy on August 19, when the notes became due and payable, in part because the bonds could have regained their value before the date they came due, and Miller had an investment strategy of holding corporate bonds to maturity. Presumably, this argument is meant to attribute the loss to other disclosures made between March 15 and August 10 by Shengda, namely its May 5, 2011 Form 8-K and its May 5, 2011 press release explaining the reasons for KPMG-HK's resignation and identifying issues in the 2008 and 2009 audit reports and with internal control deficiencies specifically. TAC ¶¶ 233-234. Had Miller alleged that the loss followed these corrective disclosures, Miller arguably would have demonstrated a sufficient connection between the disclosure and the alleged omission in the 2008 audit report regarding internal control deficiencies (leaving aside the challenges of alleging causation in light of the earlier NASDAQ changes).
But Miller has had numerous opportunities to amend its complaint, and its pleadings clearly identify the March 2011 press release as the cause of the loss. See id. ¶¶ 25 ("When ShengdaTech announced in mid-March 2011 that the 2010 audit had raised red flags, the market for Plaintiffs' bonds immediately became illiquid. Plaintiffs were unable to sell their bonds before ShengdaTech filed for bankruptcy in August 2011."), 249-250 ("Plaintiffs determined to sell their convertible bonds virtually immediately after ShengdaTech's initial announcement that KPMG had encountered unexplained discrepancies in its audit of ShengdaTech's 2010 financial statements.... Then, however, there was no liquid market for ShengdaTech's convertible bonds; thus, Plaintiffs could not sell their bonds."). Miller's arguments when pressed in service of the loss causation issue cannot serve to revise express language in its pleadings.
In addition, KPMG-HK's consent to the use of its 2008 and 2009 audit opinions in preliminary registration statements prepared for a proposed Shengda equity offering in 2010 that never occurred is not actionable, because Miller was not a purchaser of the inchoate offering and has not alleged how it could have relied on the papers prepared for it. TAC ¶¶ 213, 219.
