RAMOS, District Judge:
This case arises from allegations of an independent auditor's alleged failure to detect fraud at ChinaCast Education Corporation, Inc. ("ChinaCast" or the "Company"), an educational services company in the People's Republic of China ("China"). ChinaCast entered the U.S. capital markets through a reverse merger in 2006, and for several years, its common stock was traded on the NASDAQ. In 2012, the Company disclosed that, unbeknownst to its investors, and without consent from its Board of Directors, certain rogue employees, led by the Company's former Chairman and CEO, Ron Chan, had engaged in wide-ranging fraudulent activities, including, inter alia, misappropriation of proceeds from a stock offering, misrepresentation of ChinaCast's ownership interests, and pledging substantial portions of the Company's term deposits to cover debts of third parties. After a series of public announcements revealing the fraud, ChinaCast's stock price plummeted. Am. Compl. ¶¶ 5, 6, 45, 172-84, Doc. 4.
Plaintiffs in this action consist of an assortment of investors who, in the aggregate, purchased more than 20 million shares of common stock issued by ChinaCast. Id. ¶ 6. But rather than sue the Company, Plaintiffs contend that ChinaCast's Shanghai-based outside auditor, Deloitte Touche Tohmatsu CPA, Ltd. ("DTTC"), and its U.S. affiliate, Deloitte & Touche LLP ("Deloitte U.S.") (collectively, "Deloitte Defendants"), as well as certain former ChinaCast officers and directors (the "Individual Defendants"),
Plaintiffs assert causes of action for: violations of Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder, against DTTC and Individual Defendants (First and Third Causes of Action); violations of Section 20(a) of the Exchange Act against Deloitte U.S. (Second Cause of Action); violations of Section 18 of the Exchange Act against all Defendants (Fourth Cause of Action); and common law fraud under New York law against Deloitte Defendants (Fifth Cause of Action). Id. ¶¶ 51-171, 70, 85, 208.
Before the Court are Deloitte Defendants' respective motions to dismiss Plaintiffs' claims under Rule 12(b)(6) of the Federal Rules of Civil Procedure. Docs. 14, 32. For the reasons set forth below, the motions are GRANTED; however, the Court dismisses the First Amended Complaint ("FAC") without prejudice.
Plaintiffs are a group of investment funds, entities and individuals who purchased ChinaCast securities between March 31, 2008 through and including March 30, 2012.
Plaintiffs claim that, collectively, they invested more than $96 million on more than 20 million shares of ChinaCast stock and, as a result of the Defendants' conduct, suffered "tens of millions" of dollars in investment losses. Am. Compl. ¶ 6.
"Deloitte" holds itself out as a global accounting firm comprised of member and network firms that conduct "integrated cross-border audits." Id. ¶ 51. Deloitte
ChinaCast is a Delaware corporation with principal offices in China, and has described itself as "a leading for-profit, post-secondary education and e-learning services provider in China." Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K). The Company was initially formed as a special purpose acquisition company called Great Wall Acquisition Corporation ("Great Wall") on August 20, 2003. Am. Compl. ¶ 39. In 2006, Great Wall identified ChinaCast Communications Holdings Limited ("CCH"), an e-learning company incorporated in Bermuda and listed on the Stock Exchange of Singapore ("SGX"), as a desirable acquisition target. Id. ¶ 40. Starting in 2000, the Chinese Ministry of Education granted licenses to approximately 68 universities to conduct undergraduate and post-graduate courses by distance learning. By 2003, CCH signed with more than 15 universities to use its satellite interactive distance learning network, serving over 50,000 students nationally. Thereafter, CCH expanded its business by signing additional K-12, IT and management training customers. Bendinger Decl. Exs. 3, 6 (2009 and 2010 Form 10-Ks at 2). On December 22, 2006, Great Wall obtained a majority of the outstanding shares of CCH and subsequently changed its name to ChinaCast Education Corporation. Am. Compl. ¶ 45. In 2007, ChinaCast acquired all remaining outstanding shares of CCH and terminated the SGX listing, effecting a "reverse merger" onto the NASDAQ exchange. Id. ¶¶ 4, 45; see also Bendinger Decl. Exs. 3, 6 (2009 and 2010 Form 10-Ks at 2).
Plaintiffs allege that "ChinaCast's business did not make it a complicated company to audit." Am. Compl. ¶ 4. ChinaCast's financial statements report that it majority-owns approximately twenty-five subsidiaries and variable interest entities. Its principal subsidiary is ChinaCast Technology (BVI) Limited, which, since 1999, has provided funding for satellite broadband Internet services through the satellite operating entities ChinaCast Company Ltd. — Beijing Branch and ChinaCast Li Xiang Co. Ltd. ("CCLX").
After procuring Hai Lai in 2008, ChinaCast organized itself into two distinct groups: (1) the e-learning and training service group, encompassing all of the Company's business prior to the acquisition; and (2) the traditional university group, which offered bachelor and diploma programs to Chinese students. Id. ¶ 48; Bendinger Decl. Exs. 2-3 (Form 10-Ks at 2-3).
During the next two years, ChinaCast acquired two additional fully accredited universities: Lijang College of Guangxi Normal University ("Lijang College") and Hubei Industrial University Business College ("Hubei Industrial University"). Am. Compl. ¶¶ 49-50. ChinaCast's 2009 Form 10-K reported that, on October 5, 2009, the Company completed the acquisition of East Achieve Limited, the holding company which beneficially owned 100% of Lijang College. Id. ¶ 89. ChinaCast's 2010 Form 10-K reported that, on August 23, 2010, the Company completed the acquisition of Wintown Enterprises Limited, the holding company that beneficially owned 100% of Hubei Industrial University. Id. ¶ 117.
ChinaCast's 10-K and 10-Q filings state that the Company paid a majority of the consideration for the acquisition of each of its three physical universities. Id. ¶¶ 79-81, 90-91, 118-19. These payments represented some of the most, if not the most, significant transactions on the Company's annual cash flow statements. Id. ¶¶ 82, 92, 118-20.
As of 2010, DTTC had worked with ChinaCast and its predecessor entity for more than ten years. Id. ¶ 31. Between 2007 and 2010, DTTC served as ChinaCast's independent public auditor of record. Id. ¶ 51. DTTC's duties included reviewing the Company's condensed financial information for each fiscal quarter and performing integrated audits of ChinaCast's consolidated financial statements in accordance with U.S. Public Company Accounting Oversight Board ("PCAOB") standards and Generally Accepted Accounting Principles ("GAAP"). Id. ¶¶ 2, 31.
In making their decisions to invest in ChinaCast, Plaintiffs "read, reviewed and relied on" ChinaCast's public filings with the SEC, "including but not limited to its quarterly reports on Form 10-Q ... [and] annual reports on 10-KSB and 10-K, which included its audited year-end financial statements." Id. ¶¶ 9, 57, 70. Plaintiffs claim that "Defendants knew that Plaintiffs purchased ChinaCast securities in direct, eyeball reliance on" ChinaCast's audited financial statements, 10-Q and 10-K filings. Id. Particularly because ChinaCast's operations occurred abroad, Plaintiffs relied upon the fact that Deloitte, a "top global accounting firm," had a longterm relationship with ChinaCast and, through DTTC, represented that its audits comported with U.S. accounting standards; they trusted the Deloitte "stamp of approval." Id. ¶¶ 2-3, 9.
DTTC certified ChinaCast's audited financial statements and issued unqualified audit opinions for fiscal years 2007 through and including 2010, filed with the SEC on Form 10-K. Id. ¶ 8. In each of its audit opinions, DTTC stated (1) that it conducted its audit in accordance with PCAOB standards; and (2) that, in its opinion, "the consolidated financial statements present fairly, in all material respects, the financial position of the Company ... and the results
DTTC was not engaged to perform an audit of the Company's internal controls over financial reporting for the 2007 fiscal year. Bendinger Decl. Ex. 4 (2007 Form 10-K at F-2). For fiscal years 2008 and 2009, DTTC made, inter alia, the following representations regarding ChinaCast's internal controls in the Company's Form 10-K filings:
Bendinger Decl. Ex. 5 (2008 Form 10-K at 29-30); Ex. 6 (2009 Form 10-K at 44); Am. Compl. ¶¶ 70, 85.
DTTC expressed an adverse opinion on the Company's internal control over financial reporting as of December 31, 2010 based on a "[l]ack of sufficient skilled resources in the finance team to meet the demands of rapidly expanded businesses" and "[l]ack of contemporaneous documentation of certain decisions made by the Board of Directors." Bendinger Decl. Ex. 3 (2010 Form 10-K at F-2, 46).
Plaintiffs claim that Deloitte U.S. may be held responsible for DTTC's audit opinions, as well as ChinaCast's audited financial statements, because DTTC would not sign, and the Company did not submit, any SEC filings until Deloitte U.S. reviewed and approved them. Am. Compl. ¶¶ 32, 53-54. Deloitte U.S. controlled DTTC's audits of ChinaCast because it "had final authority over all U.S. GAAP matters," "directly communicated with ChinaCast's audit committee on key issues," provided consultation and "was involved in" all of
Ron Chan, not sued herein, was appointed CEO of CCH in 1999 at CCH's inception. In connection with the CCH acquisition, the Company and CCH had agreed that Chan and certain other individuals would serve as directors of ChinaCast. ChinaCast appointed Mr. Chan to the position of Chairman and CEO on February 2, 2007. On the same date, ChinaCast appointed Daniel Tseung and Individual Defendants Yin Jianping, Justin Tang and Richard Xue to serve as directors. Bendinger Decl. Ex. 4 (2007 Form 10-K at 27).
After a highly contentious proxy battle initiated by Ned Sherwood in December 2011, ChinaCast's shareholders voted to elect a new slate of directors in early 2012. The new board included two inside directors (Mr. Chan and Individual Defendant Santos) and four outside directors (Mr. Sherwood, Daniel Tseung, Derek Feng and Stephen Markscheid) (the "Board"). Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K). On March 26, 2012, the Board removed Ron Chan from his position as the Chairman and CEO and replaced him with Derek Feng. Am. Compl. ¶ 173. Individual Defendant Sena, who had signed a "loyalty pledge" to Chan, resigned from his position as CFO on the same day. Id. ¶¶ 189, 193. On March 29, 2012, the Board also removed Xiangyuan Jiang, the Company's former chief investment officer and president-China, another close ally of Mr. Chan. Bendinger Decl. Ex. 14 (Apr. 19, 2012 Form 8-K).
In an open letter to shareholders issued on April 2, 2012, the Board revealed that Mr. Chan and his cohorts had mounted "significant resistance" to the implementation of changes to the management team. Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K). As further explained in the letter, Ron Chan's contumacious conduct — which included thwarting the 2011 audit of the Company's financial statements — left the Board with no choice but to terminate him:
Id. Perhaps unsurprisingly, Mr. Chan and other terminated executives "chose[] to unlawfully resist their terminations by refusing to return key company property, including corporate chops necessary to run the business in China," and Chan told Derek
The Board further reported that it had "uncovered questionable activities and transactions which raise the specter of possible illegal conduct by Ron Chan and his accomplices and may have led to the frustration of the audit of the Company's financial statements." Id.; Am. Compl. ¶ 174. In addition to initiating legal action against Ron Chan, the Company reported that it notified the SEC and the NASDAQ of these incidents. Notwithstanding the gravity of Mr. Chan's misdeeds, the Company concluded its letter by reiterating that ChinaCast "is a strong company with great assets, a dedicated employee base and a skilled and independent Board of Directors." Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K).
NASDAQ suspended trading in ChinaCast's stock on the same day, due to the Company's failure to file an annual report for 2011. Am. Compl. ¶ 174; see also Complaint, SEC v. Chan Tze Ngon and Jiang Xiangyuan, No. 13 Civ. 6828(TPG) (S.D.N.Y. Sept. 26, 2013). Trading did not resume until more than two months later, on June 25, 2012. Id.; Am. Compl. ¶ 180.
On April 19, 2012, the Company issued a statement confirming that ChinaCast had fallen victim to financial fraud, and provided progress reports on its internal investigation during the following months. Am. Compl. ¶ 177. Among other things, the Company relayed that Ron Chan and his allies "remov[ed] or destr[oyed] a substantial portion of the financial documents that were located in the finance offices of the Company's Shanghai headquarters," and that they "stole some of the computers believed to be utilized by the finance department" after forcibly gaining entry. Bendinger Decl. Ex. 13 (May 14, 2012 Form 8-K); Ex. 14 (Apr. 19, 2012 Form 8-K at 2).
Ultimately, on December 21, 2012, ChinaCast "instructed investors to no longer rely on the Company's audited financials for 2009 and 2010." Am. Compl. ¶¶ 177-82. The Company reported that it had uncovered the following fraudulent activities (see id.):
On March 25, 2013, the Company announced that its financial statements in annual and quarterly reports for fiscal years 2007 through 2010, and the first three quarters of 2011, should not be relied upon, and that, effective March 19, 2013, the Board dismissed DTTC from its position as the Company's independent accountant. Bendinger Decl. Ex. 15 (Mar. 25, 2013 Form 8-K). Internal and government investigations regarding the extent of the fraud perpetrated by Ron Chan and his accomplices remain ongoing.
Plaintiffs filed the FAC on March 15, 2013. Doc. 4. Plaintiffs assert claims against DTTC for violations of Section 10(b), Rule 10b-5 and Section 18 of the Exchange Act, as well as a common law fraud claim under New York law. Proceeding on the theory that Deloitte U.S. controlled DTTC's audits, Plaintiffs assert similar claims against Deloitte U.S. for violations of Section 18 and Section 20(a) of the Exchange Act, as well as common law fraud.
At bottom, Plaintiffs contend that, had the Deloitte Defendants performed any audit at all, they would have discovered the rampant fraud at ChinaCast much earlier. The FAC describes a number of failures to comply with PCAOB and GAAP standards, as well as "red flags" that should have placed the Deloitte Defendants on notice of the fraud. Consequently, Plaintiffs assert that DTTC's statements for the years 2007 through 2010, that it conducted its audits in accordance with PCAOB standards and that ChinaCast's audited financial statements were GAAP compliant, and for the years 2008 and 2009, that the Company's internal controls over financial reporting were effective, were materially false. See Bendinger Decl. Exs. 3-6 (2007-2010 Form 10-Ks at F-2); Ex. 5 (2008 Form 10-K at 30); Ex. 6 (2009 Form 10-K at 44-45). Plaintiffs also seek to impose liability under Section 18 for false statements in ChinaCast's 10-K and 10-Q filings that Deloitte Defendants allegedly "caused to be made." Am. Compl. ¶¶ 234-47.
PCAOB standards include generally accepted accounting standards ("GAAS"), the "authoritative standards" with which auditors must comply. Id. ¶ 153. Plaintiffs claim that Deloitte Defendants "knowingly or recklessly" violated basic rules and principles found in the interpretive "Statements on Auditing Standards," known within the accounting industry as "AU,"
In addition, Plaintiffs assert that Deloitte Defendants "knowingly or recklessly" violated the following fundamental GAAP principles (see id. ¶¶ 155-56):
Had Deloitte Defendants complied with basic accounting principles, Plaintiffs assert that they would have discovered the following "red flags" symptomatic of fraud:
On November 1, 2013, Deloitte U.S. moved to dismiss all claims asserted against it on several grounds, including: (1) with respect to all claims, the FAC impermissibly utilizes group pleading and conclusory allegations; (2) with respect to Section 20(a), Plaintiffs fail to plead the elements of control and culpable participation; (3) with respect to Section 18, Plaintiffs fail to plead reliance, and cannot hold Deloitte U.S. liable because it did not "cause" ChinaCast to make any statement; and (4) with respect to common law fraud, Plaintiffs fail to adequately plead their claim. See Deloitte U.S. Mem. L. Supp. Mot. Dismiss, Doc. 15 ("Deloitte U.S. Mot. Dismiss").
On January 24, 2014, DTTC also moved to dismiss Plaintiffs' suit. DTTC contends that: (1) with respect to Section 10(b) and Rule 10b-5, Plaintiffs fail to establish an inference of scienter and fail to allege an actionable misrepresentation by DTTC; (2) with respect to Section 18, Plaintiffs fail to plead with sufficient particularity that DTTC made any misstatement, that DTTC subjectively believed any of its opinions to
When ruling on a motion to dismiss pursuant to Rule 12(b)(6), the Court must accept all factual allegations in the complaint as true and draw all reasonable inferences in the plaintiff's favor. Koch, 699 F.3d at 145; see also, e.g., Ruotolo v. City of New York, 514 F.3d 184, 188 (2d Cir.2008). However, the Court is not required to credit "mere conclusory statements" or "threadbare recitals of the elements of a cause of action." Ashcroft v. Iqbal, 556 U.S. 662, 678, 129 S.Ct. 1937, 173 L.Ed.2d 868 (2009) (citing Bell Atl. Corp. v. Twombly, 550 U.S. 544, 555, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007)); see also id. at 681, 129 S.Ct. 1937 (citing Twombly, 550 U.S. at 551, 127 S.Ct. 1955). "To survive a motion to dismiss, a complaint must contain sufficient factual matter... to `state a claim to relief that is plausible on its face.'" Id. at 678, 129 S.Ct. 1937 (quoting Twombly, 550 U.S. at 570, 127 S.Ct. 1955). A claim is facially plausible "when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged." Id. (citing Twombly, 550 U.S. at 556, 127 S.Ct. 1955). More specifically, the plaintiff must allege sufficient facts to show "more than a sheer possibility that a defendant has acted unlawfully." Id. Federal Rule of Civil Procedure 8 "marks a notable and generous departure from the hyper-technical, code-pleading regime of a prior era, but it does not unlock the doors of discovery for a plaintiff armed with nothing more than conclusions." Id. at 678-79, 129 S.Ct. 1937. If the plaintiff has not "nudged [his] claims across the line from conceivable to plausible, [the] complaint must be dismissed." Twombly, 550 U.S. at 570, 127 S.Ct. 1955.
A complaint alleging securities fraud must satisfy the heightened pleading requirements of Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act of 1995 ("PSLRA") by stating the circumstances constituting fraud with particularity. See, e.g., ECA & Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 196 (2d Cir.2009) (citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319-20, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007)). These requirements apply whenever a plaintiff alleges fraudulent conduct, regardless of whether fraudulent intent is an element of a claim. Rombach v. Chang, 355 F.3d 164, 170 (2d Cir.2004) (quoting Fed.R.Civ.P. 9(b)) ("By its terms, Rule 9(b) applies to `all averments of fraud.'").
Specifically, Rule 9(b) requires that a securities fraud claim based on misstatements must identify: (1) the allegedly fraudulent statements, (2) the speaker, (3) where and when the statements were made, and (4) why the statements were fraudulent. See, e.g., Anschutz Corp. v. Merrill Lynch & Co., Inc., 690 F.3d 98, 108 (2d Cir.2012) (citing Rombach, 355 F.3d at 170). Conditions of a person's mind — such as malice, intent or knowledge
These heightened pleading standards, when viewed together with the more general standards applicable to Rule 12(b)(6) motions to dismiss under Twombly and Iqbal, make clear that "plaintiffs must provide sufficient particularity in their allegations to support a plausible inference that it is more likely than not that a securities law violation has been committed." In re Lululemon Sec. Litig., No. 13 Civ. 4596(KBF), 14 F.Supp.3d 553, 570, 2014 WL 1569500, at *9 (S.D.N.Y. Apr. 18, 2014) (citing ECA & Local 134 IBEW, 553 F.3d at 196).
Deloitte U.S. first argues that Plaintiffs' use of the term "Deloitte" to refer collectively to Deloitte U.S. and DTTC fails to provide notice as to which allegations pertain to which Deloitte entity. Deloitte U.S. Mot. Dismiss 9. Plaintiffs claim that their allegations need not separate the particular roles of the Deloitte entities because they have adequately pleaded that Deloitte U.S. had involvement in, and control over, DTTC's audits of ChinaCast. Pls.' Opp. Deloitte U.S. Mot. 16-17, Doc. 25. Plaintiffs also note that the FAC supplements widespread use of "Deloitte," which is a term that the FAC defines to include both DTTC and Deloitte U.S., with at least 33 individualized references to Deloitte U.S. and 54 individualized references to DTTC. Id. at 16.
The Court finds that, while the term "Deloitte" is imprecise, the complaint nonetheless makes sufficiently clear that Plaintiffs' object is to hold Deloitte U.S. liable principally on a theory of vicarious liability for the actions of DTTC. Am. Compl. ¶¶ 8, 32, 53, 54, 59; In re Parmalat Sec. Litig., 375 F.Supp.2d 278, 288-89 (S.D.N.Y.2005) (describing defendant accounting firms' objections to group pleading as "well-taken," but determining that complaint gave sufficient notice of theory of liability as to each member accounting firm).
Cases such as Rocker Management, LLC v. Lernout & Hauspie Speech Products N.V., No. 00 Civ. 5965(JCL), 2005 WL 1365772, at *8 (D.N.J. Jun. 8, 2005), cited by Deloitte U.S., are distinguishable. While Rocker held that "lumping together" distinct offices of another global accounting firm, KPMG, violated Rule 9(b)'s particularity
Section 10(b) of the Securities Exchange Act of 1934 prohibits using or employing, "in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance," 15 U.S.C. § 78j(b) (1934), while SEC Rule 10b-5, promulgated thereunder, creates liability for a person who makes "any untrue statement of a material fact or to omit[s] to state a material fact ... in connection with the purchase or sale of any security." In re OSG Sec. Litig., 971 F.Supp.2d 387, 397 (S.D.N.Y.2013) (quoting 17 C.F.R. § 240.10b-5 (1951)).
To state a private civil claim under Section 10(b) and Rule 10b-5, a plaintiff must plead that: (1) the defendant made a material misrepresentation or omission, (2) with scienter, i.e., a wrongful state of mind, (3) in connection with the purchase or sale of a security, and (4) that the plaintiff relied on the misrepresentation or omission, thereby (5) causing economic loss. Dura, 544 U.S. at 341-42, 125 S.Ct. 1627; see also, e.g., Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 153 (2d Cir. 2007); Kalnit, 264 F.3d at 138.
DTTC challenges the adequacy of Plaintiffs' allegations concerning whether it (1) made a material misrepresentation or omission or (2) acted with scienter. The Court constrains its discussion accordingly and, for organizational clarity, addresses scienter first.
"[W]hile § 10(b) has been described and may have been contemplated as a `catchall' provision, `what it catches must be fraud.'" In re Livent, Inc. Noteholders Sec. Litig., 151 F.Supp.2d 371, 413 (S.D.N.Y.2001) (quoting Chiarella v. U.S., 445 U.S. 222, 234-35, 100 S.Ct. 1108, 63 L.Ed.2d 348 (1980)). Section 10(b) and Rule 10b-5 require plaintiffs to allege a state of mind demonstrating "an intent to deceive, manipulate or defraud," also known as scienter. Ganino v. Citizens Utils. Co., 228 F.3d 154, 168 (2d Cir.2000) (citing Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976)); see also, e.g., In re Philip Servs. Corp. Sec. Litig., 383 F.Supp.2d 463, 469 (S.D.N.Y.2004). To satisfy the PSLRA's pleading requirements for scienter, a plaintiff must allege facts with particularity that would give rise "to a strong inference that the defendant acted with the required state of mind." ECA & Local 134 IBEW, 553 F.3d at 198. As Supreme Court precedent dictates, a "strong inference" that a defendant acted with a certain
A plaintiff may establish scienter by alleging facts that either (1) show that the defendant had both the "motive and opportunity" to commit the alleged fraud, or (2) "constitute strong circumstantial evidence of conscious misbehavior or recklessness." Lerner v. Fleet Bank, N.A., 459 F.3d 273, 290-91 (2d Cir.2006); see also, e.g., Ho v. Duoyuan Global Water, Inc., 887 F.Supp.2d 547, 574 (S.D.N.Y. 2012). When a plaintiff fails to allege a motive to commit fraud, the plaintiff's allegations that indicate a defendant's recklessness "must be correspondingly greater." Kalnit, 264 F.3d at 142 (internal citations omitted); accord S. Cherry St., LLC v. Hennessee Grp. LLC, 573 F.3d 98, 109 (2d Cir.2009). Here, Plaintiffs solely proceed on the theory that DTTC acted recklessly with respect to the falsity of its statements.
To state a claim based on recklessness, plaintiffs may either specifically allege defendants' knowledge of facts or access to information contradicting defendants' public statements, or allege that defendants failed to check information that they had a duty to monitor. In re Longtop Fin. Techs. Ltd. Sec. Litig., 910 F.Supp.2d 561, 574 (S.D.N.Y.2012) ("Longtop I") (citing In re Gildan Activewear, Inc. Sec. Litig., 636 F.Supp.2d 261, 272 (S.D.N.Y. 2009)). To the extent that plaintiffs assert that defendants had access to contrary facts, the complaint must "specifically identify the reports or statements containing this information." Id. at 574-75 (citing Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 197 (2d Cir.2008) (quoting Novak, 216 F.3d at 309)); In re IMAX Sec. Litig., 587 F.Supp.2d 471, 483-84 (S.D.N.Y.2008). Nonetheless, it is well-settled that "fraud by hindsight" is not a cognizable theory of relief; "fraud is always obvious in retrospect, but it is not reckless to lack clairvoyance." Longtop I, 910 F.Supp.2d at 579; see also, e.g., Meridian Horizon Fund, LP v. KPMG (Cayman), 487 Fed. Appx. 636, 640-41 (2d Cir.2012) (summary order).
The pleading requirements for auditor scienter are particularly stringent. In re Advanced Battery Technologies, Inc. Sec. Litig., No. 11 Civ. 2279(CM), 2012 WL 3758085, at *15 (S.D.N.Y. Aug. 29, 2012) ("ABAT I") ("Courts in this District have repeatedly recognized [that] "[t]he standard for pleading auditor scienter is demanding.""); see also, e.g., Stephenson v. PricewaterhouseCoopers, LLP, 768 F.Supp.2d 562, 571-72 (S.D.N.Y.2011); In re Marsh & Mclennan Companies, Inc. Sec. Litig., 501 F.Supp.2d 452, 488 (S.D.N.Y.2006) (quoting Rothman v. Gregor, 220 F.3d 81, 98 (2d Cir.2000)). As the Second Circuit described in Rothman,
220 F.3d at 98.
Allegations of a negligent or "shoddy audit" fail to establish fraudulent intent. In re MRU Holdings Sec. Litig., 769 F.Supp.2d 500, 518 (S.D.N.Y.2011); In re Puda Coal Sec. Inc., Litig., No. 11 Civ. 2598(KBF), 30 F.Supp.3d 230, 248, 2014 WL 2915880, at *13 (S.D.N.Y. Jun. 26, 2014) ("Facts merely supporting an inference that an audit could have been done better constitute `fraud by hindsight' and do not support the requisite scienter."). Rather, a plaintiff must allege that the auditor employed accounting practices "so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts." In re Scottish Re Group Sec. Litig., 524 F.Supp.2d 370, 385 (S.D.N.Y.2007) (citation omitted) (alteration in original); Marsh & Mclennan, 501 F.Supp.2d at 488-89 (quoting S.E.C. v. Price Waterhouse, 797 F.Supp. 1217, 1240 (S.D.N.Y.1992)). "This standard requires more than a failure to follow GAAP." In re Scottish Re, 524 F.Supp.2d at 385. Allegations of "`accounting practices amounting at best to a pretended audit, or of grounds supporting a representation so flimsy as to lead to the conclusion that there was no genuine belief back of it,'" may support a finding of auditor scienter. Dobina v. Weatherford Int'l Ltd., 909 F.Supp.2d 228, 254 (S.D.N.Y.2012) (citations omitted).
"A complaint might reach [the] `no audit at all' threshold by alleging that the auditor disregarded specific `red flags,'" which are facts that "would place a reasonable auditor on notice that the audited company was engaged in wrongdoing to the detriment of its investors." Longtop I, 910 F.Supp.2d at 574-75 (citation omitted); see also, e.g., In re IMAX, 587 F.Supp.2d at 483-84. A plaintiff must allege that the auditor had actual awareness of the red flags, "either because they are alleged to have had actual knowledge or because the red flags were so obvious that the auditor must have been aware of them." Stephenson v. Citco Grp. Ltd., 700 F.Supp.2d 599, 622-23 (S.D.N.Y.2010), aff'd on other grounds sub nom. Stephenson v. PricewaterhouseCoopers, LLP, 482 Fed.Appx. 618 (2d Cir.2012); see also MRU Holdings, 769 F.Supp.2d at 518-19. It is insufficient to simply allege that the auditor had access to the information by which it could have discovered the fraud. Meridian Horizon Fund, LP v. Tremont Grp. Holdings, Inc., 747 F.Supp.2d 406, 413 (S.D.N.Y.2010). "Notably, if an auditor is `not aware of facts indicating that a transaction was suspicious, or part of a fraud, the auditor's failure to investigate the transaction — even if negligent — does not provide a basis for a fraud claim.'" Iowa Pub. Employee's Ret. Sys. v. Deloitte & Touche LLP, 919 F.Supp.2d 321, 332 (S.D.N.Y.2013) (quoting In re CBI Holding Co., Inc., 419 B.R. 553, 566-67 (S.D.N.Y.2009)) ("auditor access is not tantamount to auditor awareness" (emphasis in original)), reconsideration denied, 973 F.Supp.2d 459 (S.D.N.Y.2013), aff'd, 558 Fed.Appx. 138 (2d Cir.2014).
As one court observed, "[a]n auditor is a watchdog, not a bloodhound. As a matter of commercial reality, audits are performed in a client-controlled environment." Whalen v. Hibernia Foods PLC, No. 04 Civ. 3182(HB), 2005 WL 1799370, at *3 (S.D.N.Y. Aug. 1, 2005) (quoting Bily v. Arthur Young & Co., 3 Cal.4th 370, 11 Cal.Rptr.2d 51,
Blanket allegations of accounting irregularities or failure to follow GAAP, standing alone, cannot pass muster; it is well-established that such allegations must be coupled with "red flags" in order to support a strong inference of scienter. Id.; see also, e.g., W.Va. Inv. Mgmt. Bd. v. Doral Fin. Corp., 344 Fed. Appx. 717, 720 (2d Cir.2009) (summary order); In re SAIC, Inc. Sec. Litig., No. 12 Civ. 1353(DAB), 2013 WL 5462289, at *8 (S.D.N.Y. Sept. 30, 2013), on reconsideration, No. 12 Civ. 1353(DAB), 2014 WL 407050 (S.D.N.Y. Jan. 30, 2014); In re Bear Stearns Companies, Inc. Sec., Derivative, & ERISA Litig., 763 F.Supp.2d 423, 511 (S.D.N.Y.2011); Varghese v. China Shenghuo Pharm. Holdings, Inc., 672 F.Supp.2d 596, 610 (S.D.N.Y.2009); In re Refco, Inc. Sec. Litig., 503 F.Supp.2d 611, 657-58 (S.D.N.Y.2007). Likewise, on its own, the magnitude of an alleged fraud fails to establish scienter. Pennsylvania Pub. Sch. Employees' Ret. Sys. v. Bank of America Corp., 874 F.Supp.2d 341, 362-63 (S.D.N.Y.2012). Courts may infer circumstantial evidence of scienter from an auditor's failure to uncover a large-scale fraud, "just as failing to detect a large boulder in front of your face qualifies as circumstantial evidence of blindness," Longtop I, 910 F.Supp.2d at 578, but "scienter is not sufficiently alleged simply because an audit failed to detect a fraud." ABAT I, 2012 WL 3758085, at *16.
Plaintiffs contend that DTTC "recklessly" issued (1) unqualified audit opinions certifying that ChinaCast's financial statements were prepared in accordance with GAAP and that DTTC conducted the audits in accordance with PCAOB standards for fiscal years 2007 through 2010 and (2) unqualified opinions on the Company's internal controls over financial reporting for fiscal years 2008 and 2009. Am. Compl. ¶¶ 52, 83, 85, 151-52, 207-08; DTTC Mot. Dismiss 22-23 (citing 2007-2010 Form 10-Ks at F-2).
The Second Circuit has held that a "reckless disregard for the truth" signifies "conscious recklessness — i.e., a state of mind approximating actual intent, and not merely a heightened form of negligence." S. Cherry St., 573 F.3d at 109 (emphasis in original). Viewed collectively, Plaintiffs' allegations come close, but ultimately fall short of this especially stringent standard.
Plaintiffs argue that the auditor need not actually have seen the red flags if they instead establish that a reasonable auditor would have recognized them during a properly-conducted audit. Pls.' Opp. DTTC Mot. 5 (citing, e.g., In re Longwei Petroleum Inv. Holding Ltd. Sec. Litig., No. 13 Civ. 214(HB), 2014 WL 285103, at *6 (S.D.N.Y. Jan. 27, 2014); Whalen, 2005 WL 1799370, at *3). However, the law is clear that "[a]n unseen red flag cannot be heeded," Stephenson, 768 F.Supp.2d at 573, and, as another court put it, "the fact that `a person has broad access to every book in a library does not mean that the person has read and chosen to ignore facts contained in a particular book in the library.'" Athale v. SinoTech Energy Ltd., No. 11 Civ. 0531(AJN), 2014 WL 687218, at *7 (S.D.N.Y. Feb. 21, 2014) (quoting In re aaiPharma Inc. Secs. Litig., 521 F.Supp.2d 507, 513 (E.D.N.C.2007)).
The cases cited by Plaintiffs are not to the contrary. In Whalen, the court found that the complaint raised an inference that the auditor "knew or should have known about the company's alleged fraudulent accounting practices" based on plaintiffs' specific allegations of awareness of suspicious facts: a former finance manager directly told PwC that the audited company's "cash situation had become so severe [that] the Managing Director ... was paying suppliers out of his personal bank account," and the audited company fell behind on payments to the auditor itself, causing PwC to delay its audit — evidence of cash flow problems in the auditor's "own backyard." 2005 WL 1799370, at *4. Here, the Company's financial filings show only that ChinaCast failed to pay outstanding bills to DTTC after the fraud became public.
Similarly, in Longwei, the Court determined that the plaintiffs adequately alleged the auditors' scienter based on their pleading of red flags, the massive scale of the fraud, auditors' failure to follow GAAS, and "the fact that the[] [auditors] had been rebuked for audit deficiencies in the past by the [PCAOB]." 2014 WL 285103, at *5. The Court also identified specific indicia known to the auditors — record revenues far outpacing competitors, the revenues' sudden upward trajectory, and a particular investment — which "should have prompted further investigation." Id.
As with all allegations at the motion to dismiss stage, courts must view allegations of red flags "in the aggregate." In re Refco, 503 F.Supp.2d at 658 (citing Yoder v. Orthomolecular Nutrition Inst., Inc., 751 F.2d 555, 562 (2d Cir.1985)). Taken as a whole, Plaintiffs' allegations here amount to a theory that, had DTTC performed a higher quality audit, i.e., one that complied with GAAS and PCAOB standards, it would have unearthed red flags indicative of ChinaCast's pervasive wrongdoing. Yet, it is well-established that an accusation that a defendant "merely ought to have known" is insufficient to allege recklessness. Kuriakose v. Fed. Home Loan Mtg. Corp., 897 F.Supp.2d 168, 184 (S.D.N.Y.2012); Athale, 2014 WL
Of Plaintiffs' red flags, only one involves an allegation that DTTC had possession of the source documents evidencing suspicious activity: the allegation that ChinaCast's trial balances for the years 2007 through 2009 reveal "massive outflows" of cash to, and unexplained inflows from, parties that had "no legitimate business relationship" to the Company. Am. Compl. ¶ 5. Plaintiffs allege that the trial balances for CCT Shanghai, one of its subsidiaries, reveal transactions with non-education related businesses and thus render false the Company's statement in its Form 10-K filings that "CCT Shanghai does not perform any activities or have any operations outside the scope of" its satellite business. Id. ¶ 135. However, DTTC correctly notes that this statement did not appear in the Company's financial statements — the portion of the 10-K audited by DTTC. DTTC Mot. Dismiss 18.
Additionally, the Court finds persuasive DTTC's argument that, in accordance with professional accounting standards, auditors routinely employ sampling procedures. Id. at 16 (citing AU ¶ 350.07). Because Plaintiffs do not allege that DTTC was required to test the specific CCT Shanghai trial balances that they identify, their allegations amount to no more than an allegation of a lapse in professional judgment. "PCAOB standards specifically instruct auditors to `select' a sample of the audited company's journal entries for testing based on the auditor's `professional judgment.'" Id. (citing AU ¶¶ 316.58(2), 316.61). Plaintiffs only allege that a "limited sample" of the CCT Shanghai trial balances revealed dealings with a pawn shop (Am. Compl. ¶ 138), and generally claim that the trial balances "include" evidence of other transactions with unrelated parties (id. at ¶¶ 143-47, e.g.), but fail to state what proportion of the trial balances such records comprise, or why a failure to sample these particular trial balance entries represents a highly unreasonable or "extreme departure from ordinary care" approximating an actual intent to defraud. In re Scottish Re, 524 F.Supp.2d at 385; In re Lehman Bros. Sec. & Erisa Litig., 799 F.Supp.2d 258, 302-03 (S.D.N.Y.2011). Cf. In re Livent, 151 F.Supp.2d at 428-29 (denying in part motion to dismiss where, based upon its random sampling of company records, Deloitte actually concluded "that the supporting documentation indicated that there had been fraudulent classification of construction costs in many cases," but thereafter, the audited company repeatedly ignored and failed to comply with Deloitte's requests for substantiation of the suspicious transactions, and Deloitte stopped asking for back-up documentation and failed to expand sampling — reflecting an "egregious refusal to investigate the doubtful.").
Moreover, ChinaCast's business includes "provision of technical services ... equipment or property leasing ... and system maintenance." DTTC Mot. Dismiss 17 (citing 2010 Form 10-K/A at F-13, 3). Plaintiffs allege no reason why transactions with businesses providing noneducation services, such as hardware and equipment leasing, would constitute clear indicia of wrongdoing. Iowa Pub. Emps. Ret. Sys., 919 F.Supp.2d at 336 (a claim premised on audit failure may survive only if no reasonable auditor with access to the same
As for the balance of the red flags, Plaintiffs repeatedly allege access to records that would have revealed suspicious activity, not awareness of facts that would inspire any reasonable auditor to investigate, and only state, in a conclusory fashion, that DTTC's accounting violations rise to the level of "no audit at all." For example, Plaintiffs claim that, during the course of its audit, DTTC should have obtained records from the Hong Kong Companies Registry, which would have revealed that Ron Chan majority-owned CCT HK since 2003. However, in the absence of any allegation that DTTC had a reason to suspect that CCT HK was not majority-owned by the Company, this red flag is no different from an allegation that DTTC failed to comply with GAAP and PCAOB standards. See also ABAT I, 2012 WL 3758085, at *21-*22 (where audited company's financial statements for 2004-2008 represented that the company fully owned a subsidiary, but then, in 2009, the company publicly disclosed that its then Chairman and CEO and other investors were and always had been the subsidiary's true owners, court concluded that, even in combination with numerous other alleged GAAP and GAAS violations, the auditor's failure to investigate ownership interests after 2009 was not "sufficiently egregious" to raise an inference that the entire audit was a sham); accord In re Advanced Battery Techs., Inc. Sec. Litig., No. 11 Civ. 2279(CM), 2013 WL 3784134, at *3 (S.D.N.Y. Jul. 18, 2013) ("ABAT II"). Moreover, red flags embedded in publicly available documents do not support an inference of scienter. Saltz v. First Frontier, LP, 782 F.Supp.2d 61, 72 (S.D.N.Y.2010); see also Athale, 2014 WL 687218, at *7 (finding that third party's ability to discover alleged fraud without access to company's internal documents failed to establish auditor awareness; "while such discovery `certainly provides valuable evidence as to the nature and extent of the illegal activity ... it does not constitute evidence that [the auditor] noticed the activity and chose to ignore it.'").
Likewise, Plaintiffs' allegation that, for fiscal year 2009, DTTC should have confirmed with various banks that the Company actually received the proceeds from a $44 million stock offering, because if it had, it would have realized that Ron Chan diverted $35 million outside
Judge McMahon rejected precisely this type of allegation in In re Advanced Battery Technologies, another case arising from a purportedly reckless audit of a Chinese company that entered U.S. markets through a reverse merger. ABAT II, 2013 WL 3784134, at *9-*10.
Similarly, Plaintiffs' allegations that had DTTC requested confirmation from banks regarding ChinaCast's term deposits, they would have discovered the red flag of their encumbered nature; had DTTC confirmed that ChinaCast actually received $5 million from the BVI company owned by Chan, they would have realized that the money never came in; and had DTTC confirmed that ChinaCast paid the consideration for its brick-and-mortar universities, it may have uncovered suspicious activity, fall short of alleging that DTTC must have reviewed the documents containing these red flags, and then disregarded them. These types of allegations,
Unlike circumstances under which courts have found that an auditor knew of a red flag, this is not a case where the company's own filings "explicitly disclosed problems with internal controls," Stephenson, 768 F.Supp.2d at 579 (citing Varghese, 672 F.Supp.2d at 602, 610), where the auditor possessed "all the paperwork associated with the claimed bogus transactions," id. (citing In re Winstar Commc'ns, No. 01 Civ. 3014(GBD), 2006 WL 473885, at *11 (S.D.N.Y. Feb. 27, 2006)), where the auditor directly knew of the suspect transactions, id. (citing In re Philip Servs., 383 F.Supp.2d at 475), or where the auditor actively played a role in developing the company's deficient accounting practices. Id. (citing In re IMAX, 587 F.Supp.2d at 484). See also In re Livent, 151 F.Supp.2d at 428-29 (finding allegations of auditor scienter sufficient where plaintiffs established, among other things, that Deloitte knew of numerous questionable practices performed by audited company, but failed to expand its sampling, and, despite Deloitte's own expressed concerns about the audit, "continually changed the account officers in charge ... to new, inexperienced staff"); S.E.C. v. Gold, No. 05 Civ. 4713(JS)(MLO), 2006 WL 3462103, at *5 (E.D.N.Y. Aug. 18, 2006) (finding "more than a negligently performed audit" where auditor allegedly (1) knew "selling prices were below their inventory cost, thereby resulting in a loss," yet did not undertake testing that otherwise would have been required; (2) was aware of blatantly false financial information, but failed to investigate, then certified that financials complied with GAAP; and (3) "attempted to conceal the deficiencies of their work" by fabricating backdated statements).
In the aggregate, Plaintiffs' red flags and alleged accounting violations thus fail to tip the scale from negligence to recklessness. As discussed infra, at this juncture, the Court finds more forceful the competing inference that Ron Chan effectively concealed the fraud.
Courts have repeatedly held that even fraud of Madoff proportions does not, in and of itself, justify an inference of scienter in the absence of allegations of awareness of red flags. In re Tremont Sec. Law, State Law & Ins. Litig., 703 F.Supp.2d 362, 371 (S.D.N.Y.2010) (rejecting plaintiffs' allegations that auditors were "complicit in Madoff's fraud because they ignored various `red flags' and failed to uncover the Ponzi scheme despite having unfettered access to the funds' records" because plaintiffs failed to allege that the auditors "were aware of any facts indicative of Madoff's fraud that they consciously disregarded"); ABAT I, 2012 WL 3758085, at *10 ("[T]he far more suspicious success of Bernard Madoff's investment fund has been found by several Judges of this District not to constitute a `red flag' for outside auditors.").
Here, the scale of the alleged fraud "does raise questions regarding [DTTC's] performance of its audits," but ultimately fails to support a strong inference of scienter. In re Livent, Inc. Sec. Litig., 78 F.Supp.2d 194, 217 (S.D.N.Y.
To the extent that Plaintiffs argue that new management quickly unearthed the fraud, and thus it was easily discoverable, this argument suffers from hindsight bias. The Company's public filings suggest that the proxy battle culminating in Ron Chan's termination was crucial to the discovery of the fraud. In re Livent, 78 F.Supp.2d at 220 (holding that "the speed with which the fraud was discovered after the Lynx investment and the change in corporate leadership [was] deceptive:" the fraud was not unearthed during due diligence, and "the alleged orchestrators of the fraud ... had been removed from their managerial positions"). In addition, the Company did not uncover the extent of the fraud perpetrated by Chan immediately, admits that it did not even have access to all of ChinaCast's bank accounts (see Bendinger Decl. Ex. 13 (May 14, 2012 Form 8-K)), and indeed the investigation remains ongoing — facts suggestive of a more complicated fraud than Plaintiffs describe. Longtop I, 910 F.Supp.2d at 579 ("Fraud is always obvious in retrospect, but it is not reckless to lack clairvoyance.").
Even where a complaint alleges facts sufficient to support a strong inference of recklessness, a court may nonetheless dismiss the plaintiff's federal securities claims if "a reasonable person would [not] deem the inference of scienter... at least as compelling as ... opposing inference[s] one could draw from the facts alleged." Tellabs, 551 U.S. at 324, 127 S.Ct. 2499. When determining whether the facts alleged by a plaintiff support a "strong inference" of scienter, "a court must consider plausible, nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff." Id. at 323-24, 127 S.Ct. 2499. The critical inquiry is: "When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?" Id. at 326, 127 S.Ct. 2499.
The Court finds that, based upon the information allegedly available to DTTC or information that it should have known, rather than recklessness, the more compelling inference is that Ron Chan deceived DTTC, or that DTTC was "merely negligent in the exercise of professional
Moreover, at the audit committee's request, FTI consulting performed an "independent cash confirmation" of the Company's bank balances in 2011, yet did not raise any questions or concerns to the audit committee or DTTC regarding the Company's cash balances. DTTC Mot. Dismiss 15 (citing Bendinger Decl. Ex. 19 (Dec. 27, 2011 Schedule 14A Information at 17)). While the Court cannot assume that the 2011 balances were the same as the 2007-2010 balances, FTI's failure to detect fraud provides further circumstantial support for the inference of concealment.
DTTC's motion to dismiss Plaintiffs' First Cause of Action is therefore GRANTED.
While the Court has found that the First Cause of Action fails for failure to adequately plead scienter, Plaintiffs also failed to adequately plead the first element, a material misstatement or omission.
To bring a fraud claim based on a supposed misstatement in an opinion, a plaintiff must assert plausible allegations that "defendants did not [subjectively] believe the statements ... at the time they made them." City of Omaha, Neb. Civilian Employees' Ret. Sys. v. CBS Corp., 679 F.3d 64, 67 (2d Cir.2012); see also Freidus v. Barclays Bank PLC, 734 F.3d 132, 141 (2d Cir.2013) (quoting Fait v. Regions Fin. Corp., 655 F.3d 105, 110 (2d Cir.2011)). DTTC submits that Plaintiffs
Whereas DTTC posits that the pleading requirements for "subjective falsity" are, if anything, more demanding than the recklessness standard for scienter (DTTC Reply Br. 11), Plaintiffs argue that, because they have adequately alleged scienter, they necessarily have also adequately alleged subjective falsity. This is so, Plaintiffs claim, because pleading standards for subjective falsity are less demanding than those for scienter. Pls.' Opp. DTTC Mot. 19-20. In support of their position, Plaintiffs rely upon Freidus v. Barclays Bank PLC, 734 F.3d at 141, wherein the Second Circuit noted that "the pleading required for beliefs and opinions `does not amount to requirement of scienter.'" (quoting Fait, 655 F.3d at 110)).
The Court notes that, at a minimum, Plaintiffs have not plausibly alleged subjective falsity with respect to DTTC's statements and opinions that ChinaCast's financial statements complied with accounting standards and fairly presented the Company's financial position for the 2010 fiscal year. DTTC expressed an adverse opinion on the Company's internal control over financial reporting as of December 31, 2010. Bendinger Decl. Ex. 3 (2010 Form 10-K at F2 (audit report)). The Court finds persuasive Judge Rakoff's logic in Hanson v. Frazer: this would be an "odd fact" for an auditor to publicly admit if it subjectively lacked faith in its ultimate conclusion that the audited financial statements for the year presented the Company's financial position fairly. 2013 WL 5372749, at *7 (deeming allegations of subjective falsity of audit opinions insufficient where auditor pointed out that the audited company had not maintained effective internal control over financial reporting).
Section 20(a) of the Exchange Act provides as follows:
15 U.S.C. § 78t(a).
It is axiomatic that liability for a Section 20(a) violation is derivative of liability for a Section 10(b) violation. See, e.g., In re OSG Sec. Litig., No. 12 Civ. 7948(SAS), 12 F.Supp.3d 622, 631, 2014 WL 1678915, at *5 (S.D.N.Y. Apr. 28, 2014) (citing In re eSpeed, Inc. Sec. Litig., 457 F.Supp.2d 266, 297-98 (S.D.N.Y.2006)) (in the absence of a primary violation, "control person" liability under Section 20(a) cannot exist); McIntire, 927 F.Supp.2d at 121-23 (citation omitted) (same). In light of Plaintiffs' failure to adequately plead a primary violation against DTTC, their Section 20(a) claims against Deloitte U.S. cannot stand. Deloitte U.S.'s motion to dismiss Plaintiffs' Section 20(a) claim is therefore GRANTED.
In any event, the Court finds that Plaintiffs have failed to plead culpable participation with particularity. The pleading requirements for Section 20(a) claims have long been a source of contention among the Courts of Appeals. See In re Initial Pub. Offering Sec. Litig., 241 F.Supp.2d 281, 399 n. 179 (S.D.N.Y.2003) (surveying Circuit split). It is well-established that, to state a claim for "control person" liability under Section 20(a), a plaintiff must, at a minimum, plead: (1) a primary violation by the controlled person and (2) control of the primary violator by the defendant. However, as the parties acknowledge (Pls.' Opp. Deloitte U.S. Mot. 23), district courts within the Second Circuit disagree on the question of whether Section 20(a) plaintiffs must also allege "culpable participation" as a third element of their claim, or, alternatively, "whether section 20(a) created a burden-shifting framework where plaintiffs must only plead a primary section 10(b) violation and control, with defendants allowed to raise a good faith defense in their answer that can later be rebutted by plaintiffs." See, e.g., Lapin v. Goldman Sachs Grp., Inc., 506 F.Supp.2d 221, 245 (S.D.N.Y.2006) (Karas, J.) (collecting cases).
Although the Second Circuit has not formally adopted a rule requiring parties to plead the element of "culpable participation," the majority of district courts in this Circuit have required Section 20(a) plaintiffs to allege "that the defendant was, in some meaningful sense, a culpable participant in the controlled person's fraud."
Starting with SEC v. First Jersey Securities, Inc., 101 F.3d 1450,
Plaintiffs claim that, to the extent that the Court requires them to plead culpable participation, they have satisfied their burden. They argue that, because they have pleaded recklessness by the controlled entity, DTTC, they have also alleged culpable participation by the control person, Deloitte U.S. See Pls.' Opp. Deloitte U.S. Mot. 22-24. This argument fails.
Plaintiffs' alleged theory of control is that Deloitte U.S. had the final word on DTTC's audits and ChinaCast's SEC filings. Id. at 21; Am. Compl. ¶ 218. In terms of specific actions performed by Deloitte U.S., however, Plaintiffs only allege that Deloitte U.S.'s involvement in preparation of the Company's 2010 Form 10-K is emblematic of its role throughout the DTTC ChinaCast engagement, and explain that, in that instance, Deloitte U.S. directly communicated with the SEC regarding a particular write-off that it had directed ChinaCast to make. Yet, Plaintiffs do not suggest that the write-off at issue was improper or suspicious, nor does this example amount to an allegation of conscious misbehavior; at most, it is a more detailed allegation of involvement. Deloitte U.S. Mot. Dismiss 7 n. 8. Thus, even viewing the FAC in the light most favorable to them, Plaintiffs fail to provide specific facts from which the Court might conclude that Deloitte U.S. culpably participated in fraud. McIntire, 927 F.Supp.2d at 121-23; Bayerische, 902 F.Supp.2d at 474-75; cf. Pennsylvania Pub. Sch. Employees' Ret. Sys., 939 F.Supp.2d at 449 (denying motion to dismiss where plaintiff alleged that control persons were aware of and failed to disclose potential liabilities, in violation of GAAP, yet still certified statements regarding GAAP compliance).
Unlike Section 10(b) and Rule 10b-5 — the proverbial "judicial oak ... grown from little more than a legislative acorn" — Section 18 of the Exchange Act has, historically, remained a more narrow and seldom invoked provision. Ross v. A.H. Robins Co., Inc., 607 F.2d 545, 551-52 (2d Cir. 1979) (citing Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 737, 95 S.Ct. 1917,
To state a claim under Section 18, a plaintiff must plead that (1) the defendant "made or caused to be made" a false or misleading statement, (2) upon which the plaintiff actually relied, (3) resulting in loss to the plaintiff. In re Alstom SA, 406 F.Supp.2d 433, 478 (S.D.N.Y. 2005). Importantly, "[u]nlike Section 10(b)'s relaxed standard for pleading reliance... Section 18 requires that plaintiffs allege actual reliance on specific statements in covered Exchange Act filings." Marsh & Mclennan, 501 F.Supp.2d at 493 (citing 15 U.S.C. § 78r(a); Heit v. Weitzen, 402 F.2d 909, 916 (2d Cir.1968) ("Reliance on the actual 10-K report is an essential prerequisite for a Section 18 action and constructive reliance is not sufficient.")). Yet, as Plaintiffs are quick to note, they need not allege scienter to state a claim under Section 18. Pls.' Opp. Deloitte U.S. Mot. 13; Pls.' Opp. DTTC Mot. 20; In re Alstom, 406 F.Supp.2d at 480 ("Section 18, unlike Section 10(b), does not require a plaintiff to plead scienter."). Rather, a defendant's state of mind only gains relevance if asserted as a defense: a defendant can rebut Section 18 liability by proving "that he acted in good faith and had no knowledge that such statement was false or misleading." See 15 U.S.C. § 78r(a); see also, e.g., In re Stone & Webster, Inc., Sec. Litig., 414 F.3d 187, 193 (1st Cir. 2005).
Plaintiffs' theory of Section 18 liability is that DTTC and Deloitte U.S. "made or caused materially false and misleading statements to be made" in (1) the Company's annual reports filed with the SEC (Form 10-Ks) for the years ending December 31, 2009 and December 31, 2010; and (2) certain of the Company's quarterly reports (Form 10-Qs) filed with the SEC between March 31, 2010 and November 9, 2011. Am. Compl. ¶¶ 238-39.
As a threshold matter, the parties dispute whether Rule 9(b) applies to Plaintiffs' Section 18 claim. Plaintiffs acknowledge that "the Deloitte entities' audit failures are cognizable in both fraud (through recklessness) and negligence," but claim that they can plead negligence and fraud theories in the alternative. Pls.' Opp. Deloitte U.S. Mot. 14 n. 7 (citing the Third Circuit's decision in In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 271 (3d Cir. 2006)). This is permissible, they argue, because the FAC includes a disclaimer stating that, for the purposes of their Section 18 claim, Plaintiffs "expressly exclude and disclaim any allegation that could be construed as alleging fraud or intentional or reckless misconduct, as this claim is based on solely on [sic] claims of strict liability and/or negligence for false and misleading statements under Section 18 of the Securities Exchange Act." Am. Compl. ¶ 235.
Notwithstanding Plaintiffs' disclaimer, the Court finds that Plaintiffs' Section 18 claim sounds in fraud, and therefore must comply with the requirements of Rule 9(b) and the PSLRA. See In re Bear Stearns Companies, Inc. Sec., Derivative, & ERISA Litig., 995 F.Supp.2d 291 (S.D.N.Y.2014); In re Alstom, 406 F.Supp.2d at 483 n. 45 (noting that courts have not hesitated to apply Rule 9(b)'s requirements to Section 18
Viewing the FAC's factual allegations as a whole, they overwhelmingly speak in terms of Deloitte Defendants' "knowing and/or reckless" actions, not negligence. Indeed, even certain Section 18-specific allegations solely mention recklessness; for example, the subsection of the FAC entitled "Deloitte Causes the Company to Include False or Misleading Statements in Its Forms 10-Q" — which could only have relevance to Plaintiff's Section 18 claim, their lone claim premised on 10-Q filings — Plaintiffs allege that "Deloitte knowingly or recklessly by failing to conduct any audit at all, caused the Company to be make [sic] statements that were false or misleading at the time and in the light of the circumstances under which the statements were made" (Am. Compl. ¶ 197); and that "Deloitte recklessly disregarded GAAP ... and otherwise was reckless in the performance of its review, if it conducted a review at all" (id. ¶¶ 198, 202).
The Court finds the logic of In re Bear Stearns apposite: as is true of the instant case, there, the plaintiff "expressly disavow[ed] any claim of fraudulent or intentional conduct in connection with its Section 18 claim." 995 F.Supp.2d at 309. Because the complaint failed to distinguish the factual allegations supporting its Section 18 claim from its Section 10(b) and common law fraud claims, however, the court found that the plaintiff's disclaimer failed to exempt the Section 18 claim from compliance with Rule 9(b). Id.; see also In re JP Morgan Chase Sec. Litig., 363 F.Supp.2d 595, 635 (S.D.N.Y.2005) (holding that, "[d]espite their disclaimer of any claim of fraud with respect to the Section 11 claim," Rule 9(b)'s heightened pleading standards applied because "plaintiffs have alleged more than mere negligence — the entire complaint sounds in fraud."); cf. In re Refco, 503 F.Supp.2d at 632 (permitting negligence-based allegations brought under Section 11 to coexist with fraud-based allegations where plaintiffs "carefully structured" the complaint to distinguish between its Securities Act claims and Exchange Act claims, such as by including a section of factual allegations called "Defendants' Negligence.").
Accordingly, the Court will not permit Plaintiffs to disclaim their allegations of fraud simply to avoid the strictures of Rule 9(b). See Rombach, 355 F.3d at 172 ("Plaintiffs assert that their Section 11 claims do not sound in fraud but the wording and imputations of the complaint are classically associated with fraud") (internal quotations and citations omitted); accord In re Adelphia Commc'ns Corp. Sec. & Derivative Litig., 03 Md. 1529(LMM), 2007 WL 2615928, at *9 (S.D.N.Y. Sept. 10, 2007), adhered to on reconsideration, 542 F.Supp.2d 266 (S.D.N.Y.2008) (citing Rombach, 355 F.3d at 172) (plaintiff cannot "merely disclaim allegations of fraud where doing so would allow Rule 9(b) to be avoided"); id. ("The Complaint as a whole is targeted at the fraud perpetrated by [defendant] and other parties, not negligence, and the few paragraphs set aside under Count I do not alter the character of Plaintiffs' allegations.").
Deloitte U.S. and DTTC both argue that Plaintiffs' Section 18 claims must be dismissed to the extent that Plaintiffs premise them on financial statements made in ChinaCast's 10-Q filings because, as a matter of law, such statements cannot incur Section 18 liability. Deloitte U.S.
Liberally construed, the FAC alleges that Deloitte Defendants should be held liable under Section 18 for (1) statements DTTC made in its audit opinions and (2) statements that the Deloitte Defendants caused to be made in 10-Ks and 10-Qs through certification of ChinaCast's financial statements. Plaintiffs fail to cite any authority in support of its argument that the allegedly false and misleading financial statements in ChinaCast's 10-Q filings, identified by the FAC, fall outside the scope of "financial information." Indeed, SEC Form 10-Q makes plain that a Company's financial statements constitute "financial information."
Deloitte Defendants argue that an auditor only speaks through its audit opinions, and cannot be held responsible for making or causing a company to make other statements in their SEC filings, including audited financial statements. DTTC Mot. Dismiss 26; Deloitte U.S. Mot. Dismiss 19-20. Deloitte Defendants rely on the Tenth Circuit's decision in Deephaven Private Placement Trading, Ltd. v. Grant Thornton LLP, 454 F.3d 1168, 1174 (10th Cir.2006), for the proposition that an independent outside auditor cannot force an audited company to make statements in its financial filings, and that the sole end product of an audit is an audit report. Plaintiffs cannot succeed on a claim based on DTTC's audit opinions in any event, DTTC argues, because they fail to allege that DTTC subjectively believed its audit opinions to be false, as Fait requires (discussed supra at pp. 435-36).
Plaintiffs have not cited a single case adopting their theory that an auditor can be held liable under Section 18 for "causing" a company to make audited financial statements or other SEC filings, apart from its audit opinions, under circumstances such as those alleged here. Plaintiffs identify In re Adelphia Communications Corporation Securities & Derivative Litigation as the sole decision in this Circuit to address the issue of what constitutes "causing" a statement to be made for the purposes of Section 18. Pls.' Opp. Deloitte U.S. Mot. 14. In that case, Judge McKenna held that the natural meaning of "cause to be made" is that it "describe[s] actors who control the speaker in some
First, In re Adelphia fails to support Plaintiffs' position. There, Judge McKenna reasoned that an "attorney giving legal advice to a person or corporation making a statement, or assisting in its drafting," could not, "in [any] sense ... be understood to `cause' the statement to be made." Id. Analogously, auditors assist in the drafting, preparation and review of SEC filings; it stands to reason that they should not be held liable under Section 18 for performing the same function.
Plaintiffs argue that DTTC controlled ChinaCast "in some way" because its SEC filings could not have been completed without the audit opinions; however, the Court finds the Tenth Circuit's reasoning in Deephaven more logically consistent with the role of an outside auditor than the theory proposed by Plaintiffs. While auditors indeed serve the important function of "public watchdog," they "do not `certify' a company's financial statements in the sense that they `guarantee' or `insure' them. Nor do they, by virtue of auditing a company's financial statements, somehow make, own or adopt the assertions contained therein. Rather, the end product of an audit is the audit report...." Deephaven, 454 F.3d at 1174; accord Dronsejko v. Thornton, 632 F.3d 658, 663 (10th Cir.2011). Indeed, DTTC's audit opinions explicitly and consistently state that ChinaCast management is responsible for "maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting...." whereas DTTC's responsibility is to express an opinion on the Company's internal controls and/or an audit opinion. Bendinger Decl. Exs. 2-6 (2007-2010 Form 10-Ks).
Accordingly, Plaintiffs may only potentially seek liability under Section 18 for DTTC's own opinions.
Ultimately, the Court finds that Plaintiffs' Section 18 claim fails due to their failure to adequately allege the element of reliance.
DTTC contends that Plaintiffs have offered exclusively conclusory allegations of reliance in lieu of pleading any facts showing that they actually relied upon DTTC's audit opinions, the only statements that DTTC "made or caused to be made." DTTC Mot. Dismiss 28-29.
As drafted, Plaintiffs' Section 18 claim does not allege reliance on the audit opinions. Plaintiffs' Section 18 allegations are unique among Plaintiffs' claims in that, unlike all of the others, they do not commence by stating, "Plaintiffs repeat and reallege each and every paragraph contained above as if set forth herein." Compare Am. Compl. ¶¶ 234-247 with Am. Compl. ¶¶ 205, 217, 222, 248. Plaintiffs'
In its opposition briefing, Plaintiffs argue that DTTC's "false statements in its own audit opinions" nonetheless fall within the ambit of their Section 18 claim. Pls.' Opp. DTTC Mot. 21-22. Plaintiffs argue that their Section 18 allegations incorporate the other paragraphs of the FAC by reference, and thus include the allegation that "DTTC issued unqualified audit opinions [for fiscal years 2007-2010] ... Plaintiffs specifically read, reviewed, and relied on these false and misleading statements in purchasing ChinaCast Securities." Am. Compl. ¶¶ 208; see also id. ¶¶ 56-57. In response to DTTC's observation that Plaintiffs' Section 18-specific allegations (id. ¶¶ 234-247) exclude any "incorporation by reference" language, Plaintiffs characterize this failure as a "scrivener's error." Pls.' Opp. DTTC Mot. 24 n. 21.
Even accepting Plaintiffs' argument that they "clearly intended the substance of their Section 18 claim to encompass DTTC's audit opinions" (see id.) — which is at odds with the FAC's text — the FAC fails to identify any specific transactions that ensued as a result of Plaintiffs' purported "eyeball" reliance on DTTC's audit opinions. This is fatal to the claim.
In In re Bear Stearns Companies, Inc. Securities, Derivative, & ERISA Litigation, the court deemed allegations that the plaintiff, in reliance upon alleged misrepresentations in Bear Stearns' 10-K, purchased securities during a "year-long period from March 2007 through March 2008" inadequate to state a claim under Section 18. See 995 F.Supp.2d 291, 309-10 (S.D.N.Y.2014); DTTC Reply Br. 14-15 (discussing same). The court found that the plaintiff's allegations lacked the requisite particularity because they failed to "link [the plaintiff's] review of any particular statements in [the 10-K] or any other document to any actual purchases of Bear Stearns securities and [did] not identify a particular transaction that it allegedly made in reliance on the document or any other document." 995 F.Supp.2d at 309 (emphasis added). The plaintiff's response that "every SRM purchase of Bear securities was in reliance on the specific misrepresentations and omissions identified in the Complaint" could not save it; the court deemed such general proclamations insufficiently particularized. Id. Likewise, in International Fund Management S.A. v. Citigroup Inc., Judge Stein rejected as conclusory the plaintiffs' allegations that "[i]n connection with [their] purchases of Securities after February 23, 2007, Plaintiffs and/or their investment managers read and relied upon Citi's 2006 [and 2007] Form 10-K[s], including the false financial statements and other statements alleged herein to be false or misleading." 822 F.Supp.2d 368, 386 (S.D.N.Y.2011). These allegations failed to satisfy the requirements of Twombly and Iqbal, the court found, because they are conclusory, claimed reliance on "entire 10-Ks," claimed reliance "for indefinite periods of time," and failed to allege "supporting factual matter indicating how plaintiffs relied on the alleged misrepresentations." Id. (emphasis added).
Here, Plaintiffs' allegations with respect to reliance on DTTC's audit opinions likewise fail even construing them in the light most favorable to Plaintiffs, because they only state in the most general sense that
Plaintiffs argue that the Third Circuit's decision in In re Suprema "unambiguously" supports their case (Pls.' Opp. DTTC Mot. 28), but even that case makes clear that plaintiffs must plead "facts probative of [plaintiffs'] actual reliance on any specific false statements." 438 F.3d at 284. There, the Court of Appeals affirmed the district court's dismissal of the plaintiffs' "cursory" allegations that "they `received, reviewed, actually read, and relied upon'" various 10-K and 10-Q filings in making their decisions to invest in common stock because the plaintiffs failed to allege facts "show[ing] the requisite causal nexus between their purchase of securities and specific statements contained in the SEC filings." 438 F.3d at 284. Relying on precedent outside this jurisdiction, Plaintiffs repeatedly argue that the case law only requires that plaintiffs specifically identify the statements on which they relied; however, Plaintiffs' allegations of reliance on DTTC's audit opinions, unlike the eight pages of allegations pertaining to statements in ChinaCast's 10-K and 10-Q in the Section 18-specific portion of the FAC, are more brief and more broad. While Plaintiffs attempt to characterize the cases cited by DTTC, most notably Judge Stein's decision in International Fund Management S.A. v. Citigroup Inc., as solely requiring plaintiffs to specifically identify the statements on which they relied, as explained supra, more is required, such as allegations of how plaintiffs relied. 822 F.Supp.2d at 386.
Accordingly, the Court GRANTS the Deloitte Defendants' motions to dismiss Plaintiffs' Section 18 claims.
To state a claim for common law fraud under New York law, a plaintiff
Plaintiffs have failed to plead facts that give rise to a "strong inference" of scienter with respect to either Deloitte U.S. or DTTC. This failure is dispositive of Plaintiffs' common law fraud claims for the same reasons already explained with respect to their federal claims.
Accordingly, Deloitte Defendants' motions to dismiss Plaintiffs' common law fraud claim is likewise GRANTED.
In response to their opponents' request for dismissal with prejudice, Plaintiffs seek leave to amend the FAC. Pls.' Opp. DTTC Mot. 2 n. 2; Deloitte U.S. Mot. Dismiss 4; DTTC Reply Br. 15.
Rule 15 of the Federal Rules of Civil Procedure instructs courts to "freely give leave" to replead "when justice so requires." Fed.R.Civ.P. 15(a)(2). The Supreme Court has held that it would be an abuse of discretion, "inconsistent with the spirit of the Federal Rules," for a district court to deny leave without some justification, "such as undue delay, bad faith or dilatory motive on the part of the movant, repeated failure to cure deficiencies by amendments previously allowed, undue prejudice to the opposing party by virtue of allowance of the amendment, futility of amendment, etc." Foman v. Davis, 371 U.S. 178, 182, 83 S.Ct. 227, 9 L.Ed.2d 222 (1962).
The Second Circuit has stated that a court should allow leave to amend a pleading unless the non-moving party can establish prejudice or bad faith. AEP Energy Servs. Gas Holding Co. v. Bank of Am., N.A., 626 F.3d 699, 725 (2d Cir.2010) (quoting Block v. First Blood Assocs., 988 F.2d 344, 350 (2d Cir.1993)). Motions to amend are ultimately within the discretion of the district courts, Foman, 371 U.S. at 182, 83 S.Ct. 227, and they should be handled with a "strong preference for resolving disputes on the merits." Williams v. Citigroup Inc., 659 F.3d 208, 212-13 (2d Cir.2011) (quoting New York v. Green, 420 F.3d 99, 104 (2d Cir.2005)) (internal quotation marks omitted). Indeed, upon granting a motion to dismiss, the "usual
While dismissal of Plaintiffs' claims is warranted, such dismissal shall be without prejudice.
Accordingly, the Court grants Plaintiffs leave to file a motion to amend their complaint pursuant to Rule 15(a). Hanson, 2013 WL 5372749, at *8 (dismissing complaint without prejudice and granting leave to replead where plaintiffs' opposition brief and oral argument on motion cited facts and "drew inferences that are either absent from the Complaint or are not made clear there"); China Auto. Sys., 2012 WL 3205062, at *16 (granting leave to amend where additional allegations, proffered in plaintiff's opposition brief, might, if properly plead, raise a strong inference of scienter sufficient to state a Section 10(b) claim). Cf. City of Pontiac Policemen's & Firemen's Ret. Sys. v. UBS AG, 752 F.3d 173, 188 (2d Cir.2014) (denying leave to amend where plaintiffs failed to offer any "additional facts or legal theories — either on appeal or to the District Court — they might assert if given leave to amend").
The Court cautions Plaintiffs that it will only grant a motion to amend the FAC to the extent that they can correct the deficiencies noted in this Opinion. Longtop I, 910 F.Supp.2d at 581. Plaintiffs are directed to file their motion to amend within twenty (20) days of the date of this Opinion, which shall include as an exhibit a copy of the proposed second amended complaint. ABAT I, 2012 WL 3758085, at *24.
For the reasons set forth above, the Deloitte Defendants' motions to dismiss are GRANTED. Plaintiffs' motion to amend shall be due within twenty (20) days of the date of this Opinion. The Clerk of the Court is respectfully directed to terminate the motions, Docs. 14, 32.
It is SO ORDERED.
On April 2, 2014, NASDAQ again suspended trading in ChinaCast; the Company was subsequently delisted and now trades in over-the-counter ("OTC") markets. Id.; ChinaCast Education (CAST) Shareholder Alert (Jun. 2, 2014), available at http://www.nasdaq.com/press-release/chinacast-education-cast-shareholder-alert — the-law-firm-of-andrews — springer-llc-announces-an-20140602-00350.
ABAT II, 2013 WL 3784134, at *4-*5.
See SEC Form 10-Q General Instructions at 5, available at https://www.sec.gov/about/ forms/form10-q.pdf.
