SUN v. HAN et al
Filing
43
OPINION. Signed by Judge Jose L. Linares on 12/21/2015. (ld, )
NOT FOR PUBLICATION
UNITED STATES DISTRICT COURT
DISTRICT OF NEW JERSEY
CHAO SUN, Individually and on Behalf of All
Others Similarly Situated,
Civil Action No.: 15-703 (JLL)
OPINION
Plaintiff,
V.
DAQING HAN, et a!.,
Defendants.
LINARES, District Judge.
This matter comes before the Court by way of Defendant Mazars CPA
Limited (“Mazars
CPA” or “Defendant”)’s Motion to Dismiss (ECF No. 30, “Def’s. Mov.
Br.”) Plaintiff Bin Qu’s
amended putative class action complaint (“Amended Complaint”)
(ECF No. 28, “Compi.”).
Mazars CPA seeks dismissal for failure to state a claim upon which relief
can be granted pursuant
to Federal Rules of Civil Procedure 9(b) and 1 2(b)(6) and pursua
nt to the heighted pleading
requirements of the Private Securities Litigation Reform Act (“PSLR
A”). Plaintiff has opposed
this Motion, and Mazars CPA has replied to that opposition. (ECF
Nos. 38, “P1’s. Opp. Br.” and
41, “Def’s. Reply Br.”). This Court has considered the Parties’ submis
sions and rules on this
motion without oral argument pursuant to Federal Rule of Civil Proced
ure 78. For the reasons set
forth below, the Court denies Mazars CPA’s Motion to Dismiss.
BACKGROUND’
The facts as stated herein are taken as alleged by Plaintiff in the operati
ve Amended Complaint. (ECF No. 28).
For purposes of this Motion to Dismiss, these allegations are accepted
by the Court as true. See Phillips v. County of
Allegheny, 515 F,3d 224, 234 (3d Cir.2008) (“The District Court, in decidin
g a motion [to dismiss under Rule]
1
Lead Plaintiff Bin Qu brings this action individually and on behalf of a proposed class
2
of
investors who acquired securities of Telestone Technologies Corporation (“Tele
stone” or “the
Company”) between March 31, 2010 and April 16, 2013. (Compi. 1). The class seeks
remedies
¶
pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934.
(Id.). Plaintiff
alleges securities violations against Telestone, Telestone’s individual officer
s, and against
Telestone’ s outside auditor (the instant Moving Defendant, Mazars CPA), as well
as against the
allegedly related entities of Mazars Scrl and WeiserMazars LLP. (Id.
¶J
20-34). Plaintiff’s
original complaint was filed on February 2, 2015, and the operative amend
ed complaint
(“Complaint”) was filed on August 17, 2015. (ECF Nos. 1, 28).
Telestone provides wireless local-access network technologies and solutions primar
ily in
the People’s Republic of China. (Compi. ¶ 2). As the Amended Complaint explain
s, the Company
gained access to the United States market through a process known as a “reverse merger
or reverse
take-over (“RTO”)” with a United States company that had previously declared
bankruptcy. (Id.
¶ 41).
A Wall Street Journal Article cited by Plaintiff explains the RTO in this way:
In reverse mergers, a foreign company is ‘bought’ by a publicly traded U.S. shell
company.
But the foreign company assumes control and gets the shell’s U.S. listing withou
t the level
of scrutiny that an initial public offering entails. Though companies from other
countries
also engage in reverse mergers, such deals are especially common among the
Chinese. The
[Public Company Accounting Oversight Board (“PCAOB”)] says nearly three-q
uarters of
the 215 Chinese companies listing in the U.S. from 2007 to early 2010 did so
via reverse
merger.
12(b)(6), was required to accept as true all factual allegations in the compla
int and draw all inferences from the facts
alleged in the light most favorable to [the plaintiffj.”).
2
On May 14, 2015, this Court, for reasons explained in an accompanying Opinio
n (ECF No. 17), granted Plaintiff
Bin Qu’s Motion to serve as Lead Plaintiff (ECF No. 18).
2
(Id.
¶ 43, quoting Michael Rappaport, SEC Probes China Auditors, WALL STREET JOuRNAL (June
3, 2011)). Thus, Plaintiff alleges that by entering the United States market by way of an
RTO,
“Telestone was able to avoid substantial regulatory scrutiny and disclosure required in
[a
traditional initial public offering).” (Id.
¶J 40-47).
According to Plaintiff, by proceeding through
“backdoor registration” into the marketplace, there is a greater likelihood that a company will
“have significant accounting deficiencies or [act as) vessels of outright fraud.” (Id.
¶ 46, quoting
an April 4, 2011 speech by former SEC Commissioner Luis A. Aguilar).
Against this backdrop, Plaintiff explains that the telecommunications industry in China, in
which Telestone is a participant, “is dominated by three state-run businesses,” known as “the
Big
3,” who award their contracts through competitive bidding. (Id.
¶
4). The vast majority of
Telestone’s revenues—upwards of 95 percent—come from business with the Big 3.
(Id.
¶
4).
According to the Amended Complaint, there are significant risks to doing busine
ss with
Government-run companies. (Id.
¶J 4-10).
For example, Telestone’s communications with the
SEC acknowledged that: “the carriers have their own payment process which is always
not in
accordance with the terms as stipulated in contracts,” which “is why [Telestone’s days
sales
outstanding (‘DSO’) has continued to increase,” that; “[b]ecause ofthe absolute monop
oly position
of the Big 3 carriers... [the Company is] unable to exercise significant influence to
ask the Big 3
carriers to follow the terms as stipulated in our contracts,”; and that the Big 3 have
a “practice of
delaying payments.” (Id.
¶J 49-60).
During the class period, the SEC investigated Telestone’s financial reporting practic
3
es.
(Id.
¶[ 49-60).
Specifically, through a series of communications, the SEC expressed its concern
The first SEC communication referenced in the Amended Complaint is a September
24, 2012 SEC comment letter
regarding Telestone’s 2011 Form 10-Ks. (Id. 1 50).
3
over the fact that Telestone appeared to be recognizing revenue on business done with the Big 3,
despite Telestone’s own representations as to the tenuousness of doing business with these
Government-run companies. (Id. ¶J 49-60). The SEC also expressed concern over the lengthening
of Telestone’s accounts receivable turnover period from 690 days at the end of December 2011 to
a “period of 1,232 days for the three months ended June 30, 2012,” which the SEC viewed as
“indicative of deterioration in [Telestone’s] customer’s credit or ability/willingness to pay.” (Id.
¶J 50,
57). These SEC communications were made public in February 2014. (Id.
¶ 60).
Ultimately, on September 4, 2013, after its investigation into the Company’s accounting
and reporting practices, the SEC required that Telestone “file a Current Report on a Form 8-K
announcing that certain previously issued financial statements should no longer be relied on
and
to amend certain financial statements.” (Id.
¶J 2,
59). Telestone was removed from the United
States marketplace on April 17, 2013, when, according to Plaintiff, “the Company disclosed that
it was not able to file its annual report since it was unable to obtain the financial records from
one
of its subsidiaries.” (Id.
¶ 14).
The gravaman of Plaintiffs Amended Complaint is that Telestone misrepresented that its
financial statements were presented in accordance with Generally Accepted Accounting
Principles
(“GAAP”)
‘
and that, contrary to GAAP, it recognized revenue where the collectability of that
revenue was not reasonably assured. Specifically, Plaintiff alleges that
Telestone’s business practice throughout the Class Period was to immediately recogn
ize
revenue upon the delivery of goods and services to the Big 3. This practice, however,
ignored that the Big 3 refused to honor the terms of the contract by not paying Telesto
ne
“GAAP is ‘a technical accounting term that encompasses the conventions, rules,
and procedures necessary to
define accepted accounting practices at a particular time.” In re Ikon Office Solutions,
Inc., 277 F.3d 658, 663 n. 2
(3d Cir, 2002) (citing American Institute of Certified Public Auditing Standards No.
69, ¶1 69.02 (1992)). “[The] single
unified purpose of [GAAP]... [is) to increase investor confidence by ensuring
transparency and accuracy in
financial reporting.” Gould v. Winstar Communications, Inc., 692 F.3d 148, 153
n.5 (2d Cir. 2012)
4
or by paying the Company years later at their own discretion. Moreover, due to the Big
3’s monopoly position and governmental states, [sic) Telestone admittedly was unable to
do anything about this non-payment, refusing to demand payment or to seek legal recourse
against these customers.
(ld.f 5).
With regards to the Moving Defendant, Mazars CPA, Plaintiff alleges that “[i]n spite of
the clear evidence of Telestone’s customers not honoring its purported contracts with the
Company, Telestone’s auditors simply buried their heads in the sand and rubber-stamped the
Company’s conclusions regarding the propriety of its revenue recognition policy.” (Id.
¶ 10).
Thus, Plaintiff claims that Mazars CPA, through its Audit Reports issued during the class period,
materially misrepresented to investors that Telestone’ s financial reports reliably represented the
Company’s financial status, that these financial reports were GAAP-compliant, and that the Audit
Reports themselves were compliant with Generally Accepted Auditing Standards (“GAAS”).
5
According to the Amended Complaint, the market gradually learned that there may have
been an issue with Telestone’ s revenues when its accounts receivable figures ballooned, which
resulted in the Company’s stock price declining significantly during the Class Period. (Id.
¶J 11-
14, 138). Specifically, on May 15, 2012, August 14, 2012, and November 19, 2012, Telestone
issued three press releases disclosing that its accounts receivable and accounts receivable turnover
period were greatly increasing. (Id.
¶ 138). Plaintiff now alleges violations of Section 10(b) of
the Securities Exchange Act against all Defendants, and violations of Section 20(a) of the
Act
against the individual Defendants. (Id. at 8 1-86). Defendant Mazars CPA now moves to
dismiss
GAAS are the standards prescribed by the Auditing Standards Board of the American
Institute of Certified Public
Accountants for the conduct of auditors in the performance of an examination.” In re
Ikon, 277 F.3d at 663, n. 5.
5
the claims against it. (Def’s. Mov. Br.). Plaintiff has opposed this motion (ECF No.
38, “P1’s.
Opp. Br.”), and Mazars CPA has filed a reply to that opposition (ECF No. 41, “Def’s. Reply Br.”).
LEGAL STANDARD
Federal Rule of Civil Procedure 8(a) requires that a Complaint set forth “a short and plain
statement of the claim showing that the pleader is entitled to relief.” Fed. R. Civ. P 8(a)(2)
. The
plaintiff’s short and plain statement of the claim must “give the defendant fair notice
of what the
claim is and the grounds upon which it rests.” Bell Atlantic Corp. v. Twombly, 550
U.S. 544,
545 (2007) (quoting Conley v. Gibson, 355 U.S. 41, 47 (1957)). For a complaint
to survive
dismissal, it “must contain sufficient factual matter, accepted as true, to ‘state a claim to relief
that
is plausible on its face.’ “Ashcrofi v. Iqbal, 556 U.S. 662, 678 (2009) (quoting Twombly,
550 U.S.
at 570).
In evaluating the sufficiency of a complaint, a court must “accept all well-pleaded factual
allegations in the complaint as true and draw all reasonable inferences in favor of the
non-moving
party.” Phillips v. County ofAllegheny, 515 F.3d 224, 234 (3d Cir.2008) (quotations
omitted).
“Factual allegations must be enough to raise a right to relief above the specul
ative level.”
Twornblv, 550 U.S.at 545.
Further, “[aj pleading that offers ‘labels and conclusions’ or ‘a
formulaic recitation of the elements of a cause of action will not do. Nor does a
complaint suffice
if it tenders ‘naked assertion[s’ devoid of ‘further factual enhancement.” Iqbal,
556 U.S. at 678
(quoting Twombly, 550 U.S. at 555, 557); Evancho v. Fisher, 423 F.3d 347, 350
(3d Cir.2005)
(“[A] Court need not credit either ‘bald assertions’ or ‘legal conclusions’ in a compla
int when
deciding a motion to dismiss.”). To that end, a Court considering a motion
to dismiss must take
account of the elements necessary to plead the claims alleged in the complaint.
6
In addition to meeting Rule 8(a)’s pleading requirements, a plaintiff alleging claims of
securities fraud must meet the heightened pleading requirements of Federal Rule of Civil
Procedure 9(b) and the Private Securities Litigation Reform Act (“PSLRA”). Rule 9(b) provid
es
that a party alleging fraud “must state with particularity the circumstances constituting fraud.”
Fed. R. Civ. P. 9(b). Thus, at a minimum, plaintiffs must plead their allegations of securities fraud
with ‘the who, what, when, where and how: the first paragraph of any newspaper story.”
Institutional Investors Group v. Avaya, Inc., 564 F.3d 242, 253 (3d Cir. 2009).
Similarly, as per the PSLRA, a plaintiff must satisfy heightened pleading requirements and
“state with particularity both the facts constituting the alleged violation, and the facts eviden
cing
scienter, i.e., the defendant’s intention ‘to deceive, manipulate, or defraud.” Tellabs, Inc. v. Makor
Issues & Rights, Ltd., 551 U.S. 308, 313 (2007) (quoting Ernst & Ernst v. Hochfelder, 425
U.S.
185, 194, and n. 12 (1976), and citing 15 U.S.C.
§ 78u—4(b)(1), (2)).
First, with regard to misleading statements and omissions of material fact, a plaintiff must
“specify each statement alleged to have been misleading, the reason or reasons why the statem
ent
is misleading, and, if an allegation regarding the statement or omissions is made on inform
ation
and belief, the complaint shall state with particularity all facts on which that belief is formed.”
15
U.S.C.
§ 78u-4(b)(1). Further, “[tb be actionable, [the) statement or omission must have been
misleading at the time it was made; liability cannot be imposed on the basis of subsequent events.”
In re NAHC, Inc. Sec. Litig., 306 F.3d 1314, 1330 (3d Cir. 2002).
As to scienter, the second requirement, “with respect to each act or omission alleged
to
violate [Section 10(b)], [a plaintiff must] state with particularity facts giving rise
to a strong
inference that the defendant acted with the required state of mind.” 15 U.S.C.
§ 78u4(b)(2). In
evaluating whether a complaint meets this requirement, a court is required to consider
inferences
7
urged by the plaintiff as well as “competing inferences rationally drawn from the facts alleged.”
Tellabs, 551 U.S. at 314. A “strong” inference is “more than merely plausible or reasonable-it
must be cogent and at least as compelling as any opposing inference of nonfraudulent intent....
The inference
.
.
.
need not be irrefutable, i.e., of the ‘smoking-gun’ genre, or even the ‘most
plausible of competing inferences.” Id. at 314, 324 (internal quotations omitted). The Third
Circuit permits a plaintiff to show a “strong inference” of fraud “either (a) by alleging facts to
show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts
that constitute strong circumstantial evidence of conscious misbehavior or recklessness.” In re
Suprerna Specialties, Inc. Sec. Litig., 438 F.3d 256, 276 (3d Cir. 2006) (quotations omitted).
In this context, “recklessness includes: ‘highly unreasonable [conduct], involving not
merely simple, or even inexcusable negligence, but an extreme departure from the standards of
ordinary care,.
.
.
which presents a danger of misleading buyers or sellers that is either known to
the defendant or is so obvious that the actor must have been aware of it.” S.E.C. v. The Infinity
Grp., Co., 212 F.3d 180, 192 (3d Cir. 2000) (quoting McLean v. Alexander, 599 F.2d 1190, 1197
(3d Cir. 1979)). Finally, a court considers the entirety of a complaint in determining “whether all
of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether
any
individual allegation, scrutinized in isolation, meets this standard.” Tellabs, 551 U.S. at 323
(emphasis in original).
DISCUSSION
Here, as to the Moving Defendant, Plaintiff seeks relief under Section 10(b) of the
Securities Exchange Act of 1934. (Compi.
173-183). “Section 10(b) prohibits the ‘use or
¶J
employ, in connection with the purchase or sale of any security,
.
.
.
[of] any manipulative or
deceptive device or contrivance in contravention of such rules and regulations as the Commission
8
may prescribe.
.
. .“
In re Ikon Office Solutions, Inc., 277 F.3d 658, 666 (2002) (quoting 15 U.S.C.
§ 78j(b)). Rule 1 Ob-5, in turn, created a private right of action for investors harmed by materially
false or misleading statements to enforce Section 10(b), and it “makes it unlawful for any person
‘[tb make any untrue statement of a material fact or to omit to state a material fact necessary to
make the statements made in the light of the circumstances under which they were made, not
misleading.
.
.
in connection with the purchase or sale of any security.” Id. (quoting 17 C.F.R.
§
240.1 Ob-5(b)).
To establish liability under 10(b) and lOb-5, a plaintiff must show:
a material misrepresentation (or omission); (2) scienter, i.e., a wrongful state of mind;
(3) a connection with the purchase or sale of a security; (4) reliance, often referred
to in
cases involving public securities markets (fraud-on-the-market cases) as “transaction
causation;” (5) economic loss; and (6) “loss causation, “i.e., a causal connection between
the material misrepresentation and the loss.
(1)
Dura Pharm, Inc. v. Broudo, 544 U.S. 336 (2004) (citations omitted).
Defendant contends that Plaintiffs Amended Complaint should be dismissed because Plaintiff
has failed to meet the heighted pleading standards of a securities fraud claim.
Specifically,
Defendant claims that Plaintiff has failed to identify the role of Mazars CPA in the alleged fraud
vis a vis the other Defendants, that Plaintiff has not identified any material misrepresentations
made by Mazars CPA, and that the Amended Complaint fails to adequately plead scienter. (Defs.
Mov. Br. at 11-40). Lastly, Defendant contends that Plaintiffs allegations of loss causation
are
barred by the two-year statute of limitations. (Id. at 3 6-40). The Court considers each of these
challenges in turn
6
A. The Amended Complaint Sufficiently Identifies the Party who Allegedly Committed
the Fraud
6
As Defendant has not seriously disputed that Plaintiff has sufficiently plead reliance, economic loss,
or loss
causation, this Court need not address whether those elements are sufficiently plead.
9
Defendant contends that the Amended Complaint should be dismissed because it improperly
relies upon group pleadings. (Def’s. Mov. Br. at 14). Specifically, Mazars CPA alleges that
Plaintiff “fails to specifically plead the role of Mazars CPA or identify specific statem
ents
attributable to Mazars CPA.” (Id.). Defendant points to Plaintiff’s use of collective phrases such
as “Mazars Entities” or “Auditors” throughout the Amended Complaint. (Id. at 14).
Defendant relies upon the Third Circuit case of Winer Family Trust v. Queen in support of its
argument that Plaintiff improperly relies upon the group pleading doctrine. (Id. at 14) (citing
Winer Family Trust v. Queen, 503 F.3d 319 (3d Cir. 2007)). In Winer Family Trust,
the Third
Circuit was asked to consider, inter a/ia, whether former shareholders could assert liabilit
y on the
part of individual directors and officers of two corporations on the basis of said individ
ual
defendants’ “access to, control over, and ability to edit and withhold dissemination of
[the
company’s] press releases and SEC filings.” 503 F.3d at 334-335. The Third Circuit defined
the
group pleading doctrine as: “[A] judicial presumption that statements in group-publish
ed
documents including annual reports and press releases are attributable to officers and
directors
who have day-to-day control or involvement in regular company operations.” Id. After
reviewing
the purposes of the PSLRA and the discussion in Tellabs regarding the substantially height
ened
pleading requirements in securities class action lawsuits, the Third Circuit held that plainti
ffs could
not rely upon the group pleading doctrine in a case arising under the PSLRA, becaus
e the PSLRA
“requires plaintiffs to specify the role of each defendant, demonstrating
each defendant’s
involvement in misstatements and omissions.” Id. at 335-37. Thus, the Circuit held that
the group
pleading doctrine is no longer viable in private securities actions after the
enactment of the
PSLRA,” Id. at 335-37.
10
Plaintiff responds that its allegations of wrongful conduct as against Mazars CPA are quite
clear from the face of the Amended Complaint which includes the text of Audit Reports issued
and signed by “Mazars CPA Limited,” which contain the alleged false statements. (P1’s. Opp. Br.
at 1113),
This Court agrees with Plaintiff that he has sufficiently identified the misstatements allegedly
made by Mazars CPA where Plaintiff has reproduced the Audit Reports signed off by “Mazars
CPA Limited” which contain the alleged misstatements, and which include the dates during which
the Audit Reports were issued and also identifies how the statements were disseminated to the
public. (See Compl. ¶j 124-127). Accordingly, Mazars CPA is sufficiently on notice of the fraud
allegations pled against it, and the Court therefore rejects its argument that the Amended
Complaint should be dismissed on the basis that Plaintiff failed to specifically identify the party
that allegedly committed the fraud.
B. Plaintiff has Sufficiently Plead Material Misstatements or Omissions
As discussed above, to survive a motion to dismiss on claims brought under the PSLRA, the
Amended Complaint must “specify each statement alleged to have been misleading, the reason or
reasons why the statement is misleading, and, if an allegation regarding the statement or omissions
is made on information and belief, the complaint shall state with particularity all facts on which
that belief is formed.” 15 U.S.C.
§ 78u—4(b)(1).
Mazars CPA contends that Plaintiff has failed to allege particularized facts showing a material
false statement made by Mazars CPA. (Def’ s. Mov. Br. at 17-21). The gravaman of Mazars
CPA’ s argument relating to the allegedly false statement component of Plaintiff’s 10(b) claim
is
that Plaintiff has failed to plead anything more than “a misstatement or error in the company’s
accounting,” which errors cannot support claims against an outside auditor. (Id. at 17-19). Mazars
11
CPA also contends that “there are no allegations that the facts used by Telestone to support its
revenue recognition were false.” (Id. at 20).
Plaintiff responds that “with respect to each factual statement that is alleged to be false or
misleading, [he] has identified who made the statement (i.e., Mazars CPA), when it was made
(2009-2011), and how it was disseminated to the investing public (e.g. ‘clean’ audits by Mazars
CPA).” (P1’s. Opp. Br. at 13-14).
Specifically, Plaintiff alleges that Mazars CPA’s Audit Reports falsely stated that: (1)
Telestone’s financial statements were presented “in conformity with accounting principles
generally accepted in the United States of America” (Id. at 11-12; Compl.
¶J 125-127); (2)
Telestone’s annual reports “present fairly, in all material respects, the financial position of the
Company” as of December 31, 2009, December 31, 2010, or December 31, 2011 as well as “the
results of its operations and cash flows for each of the years then ended”; (3) Mazars CPA
“conducted [their] audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States)” (PCAOB)(Pl’s. Opp. Br. at 11-12; Compl.
¶J 125-127), and; (4)
that “the Audit Reports were also false and misleading because Telestone’ s internal controls were
not effective but were instead plagued by significant material weaknesses” (Compl.
¶ 128). The
Court considers each of the alleged misrepresentations, in turn.
i.
Mazars CPA’s Statements that Telestone’s Financial Reports were Compliant
with GAAP
The gravaman of Plaintiffs claims is that Telestone failed to apply basic accounting principles
of revenue recognition, thereby inflating financial reports. The Amended Complaint quotes
the
following language out of Telestone’s Form 10-Ks, relating to the Company’s own revenue
recognition policy: “The Company generally recognizes product revenue when persuasive
12
evidence of an arrangement exists, delivery occurs, the fee is
fixed or determinable, and
collectability is probable.” (Compl.
¶
63). This policy tracks Generally Accepted Accounting
Principles, particularly Staff Accounting Bulletins 101 and 104,
which “represent practices
followed by the staff in administering SEC disclosure requirements.
” (Id.
¶J
61-64). Plaintiff
alleges that, in violation of these principles, Telestone reported revenu
e upon delivery of goods
and services to its Big 3 clients, even though: (1) there was not
persuasive evidence that a
substantive arrangement existed as between the Big 3 and Telesto
ne; (2) payment was not
reasonably assured, and; (3) the price was not fixed or determinable.
(Id. ¶ 66-75). Plaintiff points
to Telestone’ s correspondence with the SEC to demonstrate these deficie
ncies.
As to the lack of persuasive evidence of an arrangement between the
Big 3 and Telestone,
Plaintiff cites to Teleistone’s admissions to the SEC that “the [Big
3j have their own payment
process which is always not in accordance with the terms as stipula
ted in contracts.” (Id.
¶ 71).
This admission, according to Plaintiff, demonstrates that Telestone’s
Government clients are free
to stray from the agreed-upon terms, virtually rendering the contrac
ts a nullity. (Id.
¶ 71).
This
admission is equally bearing on the GAAP reporting requirement
that reported revenue be “fixed
or determinable,” where, according to Plaintiff, “a factor that impact
s the determination ofwhether
an arrangement is fixed or determinable is whether the custom
er has been granted extended
payment terms.” (Id.
¶ 73).
Lastly, Plaintiff directs the Court to Telestone’ s admissions bearing
on the Company’s ability
to enforce its contracts against the Big 3, tending to show that the
collection of revenue from the
Big 3 was not reasonably assured. (Id.
¶J 78-87).
Telestone informed the SEC that there exists
“uncertainty” in the payment cycles of its Big 3 customers, which
“therefore causes uncertainty in
our cash flows.” (Id. ¶ 83). The Amended Complaint also include
s a chart, prepared by Telestone,
13
which tracks an increase in delay of payment (or “days sales outstanding” (“DSO”)) from 358 days
in 2009 to 1,232 days in 2012 and an increase in the Company’s net accounts receivable from $89
million in 2010 to over $192 million in 2011. (Id.
¶J 79-80).
These increases, according to both
Plaintiff and the SEC, are indicative of Telestone’s customers’ ability and/or willingness to pay,
and therefore would suggest that collectability of reported revenue is “not reasonably assured,” as
required under SABs 101 and 104 and the Company’s own revenue collection policy. (Id.
¶J 50,
57, 79),
Plaintiff alleges that based upon these “accounting irregularities,” Telestone violated numerous
accounting principles in addition to SABs 101 and 104. (Id.
¶ 91).
Specifically, Plaintiff alleges
that Telestone violated the following Statements of Concepts promulgated by the Financial
Accounting Standards Board (“FASB”):
7
•
The principle that “financial reporting should provide information that is useful to presen
t
to potential investors and creditors and other users in making rational investment, credit,
and similar decisions” (FASB Statement of Concepts No. 1, 34);
•
The principle that “financial reporting should provide information about the economic
resources of an enterprise, the claims to those resources, and effects of transactions, events,
and circumstances that change resources and claims to those resources” (FASB Statement
of Concepts No. 1, 40);
•
The principle that “financial reporting should provide information about an enterprise’s
financial performance during a period” (FASB Statement of Concepts No. 1, 42);
According to the FASB website, “[s]ince 1973, [FASB] has been the designated
organization in the private sector
for establishing standards of financial accounting that govern the preparation of financial
reports by
nongovernmental entities. Those standards are officially recognized as authoritative
by the [SEC]
Such
standards are important to the efficient functioning of the economy because decisions
about the allocation of
resources rely heavily on credible, concise, and understandable information.”
FASB, Facts About FASB,
http;//wwwfasb.org/jsp/FASB/Page/SectionPage&cid1176154526495 (last visited
Dec. 7, 2015).
..
14
.
.
The principle that “financial reporting should provide information about how management
of an enterprise has discharged its stewardship responsibility to owners (stockholders)
for
the use of enterprise resources entrusted to it” (FASB Statement of Concepts No. 1, 50);
•
The principle that “financial reporting should be reliable in that it represents what
it
purports to represent” (FASB Statement of Concepts No. 2, 5 8-59);
•
The principle [of] “completeness, meaning that nothing is left out of the information
that
may be necessary to insure that it validly represents underlying events and condit
ions”
(FASB Statement of Concepts No. 2, 79);
•
The principle that “conservativism be used as a prudent reaction to uncertainty to try
to
ensure that uncertainties and risks inherent in business situations are adequa
tely
considered” (FASB Statement of Concepts No. 2, 95).
(Compi,
¶ 91).
As the alleged GAAP violations relate to Mazars CPA, Plaintiff claims that notwit
hstanding
these violations, Mazars CPA issued Audit Reports during the class period, which represe
nted that
Telestone’s financial reporting is compliant with GAAP. (Id.
¶J 125-127). Specifically, the Audit
Reports issued in 2009-2011 state that Telestone’s reporting was “in conformity with
accounting
principles generally accepted in the United States of America” and that “[in
Mazars CPA’s]
opinion, the consolidated financial statements
.
.
.
present fairly, in all material respects, the
financial position of the Company as of December 31, [2009, 2010 and 2011] and
the results of its
operations and its cash flows for each of the years then ended in conformity
with accounting
principles generally accepted in the United States of America.” (Compl.
¶J 125-127).
Defendant rejects Plaintiff’s logic that because Telestone’s purported violati
on of revenue
reporting principles, Mazars CPA is liable. First, Defendant argues that Plainti
ff has not alleged
“that the facts used by Telestone to support its revenue recognition were
false. Instead, the
Amended Complaint is about Telestone’s application of a discretionary accoun
ting standard to
15
those facts.” (Def’s. Mov. Br. at 20). Defendant further argues that increases in DSO
and accounts
receivable periods during the period preceding the class period does not indicate
the tenuousness
of payment by the Big 3 clients; rather, Mazars CPA argues that a review of these
numbers during
the years prior to the Class Period demonstrates a similar trend, indicating that
the appropriate
inference to be made by the increase in these figures is that such increases are
and had been “a
reality of Telestone’s business” that had been disclosed to the market at that time.
(Id. at 29).
While the Court has reviewed Defendant’s arguments that Plaintiff has failed
to plead any
actual GAAP violations, the Court finds that “[alt the pleading stage..
.
[Plaintiff is] entitled to
,
the benefit of all reasonable inferences based on the detailed and specific allegat
ions in [his]
[C]omplaint[],” Suprema, 438 F.3d at 281; see also Tellabs, 551 U.S. at 322 (“[Flac
ed with a Rule
1 2(b)(6) motion to dismiss a
§ 10(b) action, courts must, as with any motion to dismiss for failure
to plead a claim on which relief can be granted, accept all factual allegations in
the Complaint as
true.”). Based upon the Amended Complaint’s admissions from Telestone to
the SEC, as well as
the circumstantial evidence relating to the Company’s increasing accounts receiva
bles and delays
in payment, the Court finds that Plaintiff has sufficiently alleged that Telesto
ne’ s financial
reporting was inconsistent with GAAP at the pleading stage.
Defendant further contends that Plaintiff misunderstands the objectives of
an audit, which
“does not guarantee that a client’s accounts and financial statements are correct
any more than a
sanguine medical diagnosis guarantees well-being,” In re Ikon, 277 F.3d
at 673, but rather only
requires that an auditor exercise due professional care. (Def’s. Mov. Br.
at 18-19). Thus, to the
extent there were misstatements in the Company’s reporting, Mazars CPA
contends that those
misstatements are not actionable. (Id. at 19). Similarly, Mazars CPA argues
that the Audit Reports
did not, by their terms, “provide absolute assurance that Telestone’ s financi
al statements were free
16
of material misstatement: each report was an ‘opinion’ performed by ‘examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements’ providing
a
‘reasonable basis’ for the opinion.” (Id. at 20).
Here, the allegations raised by Plaintiff as to Mazars’ CPA rise above claims of failure to
“exercise due professional care” and claims of mere “misstatements” by the Company’s reporti
ng.
Plaintiff sufficiently alleges that Telestone misrepresented its financial status to its investo
rs—it
does not allege an immaterial accounting error. To that end, Mazars CPA’s statements that
its
Audit Reports did not “prove absolute assurances that Telelstone’s financial statements
were
material misstatements” cannot overcome these particular allegations against it. Accordingly,
this
Court finds that Plaintiff has sufficiently alleged that Mazars CPA made a materi
al
misrepresentation in its 2009, 2010, and 2011 Audit Reports, when it represented that Telesto
ne’s
reporting was “in conformity with accounting principles generally accepted in the United States
of America,” (Id.).
ii.
Mazars CPA’s Statements Regarding the Accuracy of Telestone’s Financial
Reporting
Plaintiff also alleges that Mazars CPA misrepresented in its Audit Reports that Telesto
ne’s
financial reports “present fairly, in all material respects, the financial position of the Compa
ny” as
of December 31, 2009, December 31, 2010, or December 31, 2011 as well as “the results
of its
operations and cash flows for each of the years then ended.” (Id.). In light of the above discuss
ion
of Telestone’s alleged inflation of revenue reporting, this Court agrees that this
alleged
misrepresentation, as pled, is sufficiently supported by the factual record alleged
in Plaintiff’s
Amended Complaint.
iii.
Mazars CPA’s Statements that its Audits were PCAOB-Compliant
17
By way of a third material misstatement, Plaintiff contends that Mazars CPA’ s Audit
Reports falsely stated that the audits were PCAOB-compliant.
8
(Compi.
¶ 129-135). According
to Plaintiff, Mazars CPA violated numerous PCAOB principles and guidelines. (See Compi.
¶J
130-135).
For example, the Amended Complaint alleges violations of Codification of Auditing
Standards Sections 312.01 and 312.16, which require an auditor to “assess audit risk and
materiality.
.
in determining the nature, timing and extent of audit procedures and in evaluating
the results of those procedures” and provide that “in considering audit risk, ‘the auditor should
specifically assess the risk of material misstatements of the financial statements due to fraud.”
(Compl.
¶ 30). Similarly, Plaintiff cites to Auditing Standard Section 326, which provides that
“[m]ost of the independent auditor’s work in forming his or her opinion on financial statem
ents
consists of obtaining and evaluating evidential matter concerning the assertions in such financi
al
statements” and that “[tb the extent the auditor remains in substantial doubt about any asserti
on
of material signiticance, he or she must refrain from forming an opinion until he or she has obtain
ed
sufficient competent evidential matter to remove such substantial doubt or the auditor must expres
s
qualified opinion or a disclaimer of opinion.” (Id.
¶ 135).
Here, Plaintiff argues that Mazars CPA violated these standards in failing to heed the red
flags (discussed in Part C, supra) which he alleges should have put the auditors on notice
of the
risks in the Company’s reporting, and in merely “rubber-stamping” Telestone’s financi
al reports.
The PCAOB (Public Company Accounting Oversight Board), “is directed by the Sarbanes-Ox
ley Act of 2002 to
establish auditing and related professional practice standards for registered public
accounting firms to follow in
the preparation and issuance of audit reports.” PCAOB, Standards Tab,
http://pcaobus.org/Standards/Pages/default.aspx (last visited Dec. 7, 2015).
18
(P1’s.
Opp.
Br. at 14). Plaintiff contends that “[a] proper audit would have uncovered that the
Company lacked any reasonable hope of payment.” (P1’s. Off. Br. at 3).
Plaintiff also alleges that the Audit Reports were not, as they claimed, PCAOB-compliant
because Reports are inconsistent with the “Objectives and Standards” of the accounting profess
ion,
which provide that:
The Function of financial reporting is to provide information that is useful to those who
make economic decisions about business enterprises and about investments in or loans
to
business enterprises. Independent auditors commonly examine or review financi
al
statements and perhaps other information, and both those who provide and those who
use
that information often view an independent auditor’s opinion as enhancing the reliability
or credibility of the information.
(Id.
¶
131). In light of this standard, Plaintiff alleges that by falsely certifying that Telesto
ne’s
financial reports were GAAP-compliant and that the financial reports fairly represe
nted the
Company’s financial health, Mazars CPA “discouraged investors from questioning the
accuracy
of those statements.” (Id.
¶ 134).
In response, Defendant accuses Plaintiff of citing to these standards “witho
ut an
explanation of how the [Diefendant knowingly or recklessly violated those standa
rds.” (Def’s.
Mov. Br. at 18) (quoting Suprema, 438 F.3d at 280). Indeed, Defendant argues that “[r]ely
ing on
purported GAAP violations, Plaintiff asks the Court to conclude that, as a necessary
consequence,
the auditors committed flagrant violations of numerous auditing standards.” (Id. at 18).
Defendant
again contends that Plaintiff misunderstands the objectives of an audit, which does
not guarantee
the accuracy of a client’s financial reporting, but rather only requires that an auditor
exercise due
professional care. (Def’s. Mov. Br. at 18-19) (quoting In re Ikon, 277 F.3d
at 673). Thus,
according to Mazars CPA, to the extent there were misstatements in the Compa
ny’s reporting,
those misstatements are not actionable as against Mazars CPA. (Id. at 19).
Additionally, as
19
discussed above, Mazars CPA argues that the Audit Reports did not, by their terms, “provide
absolute assurance that Telestone’s financial statements were free of material misstatement: each
report was an ‘opinion’ performed by ‘examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements’ providing a ‘reasonable basis’ for the opinion.” (Id. at
20).
The Court finds that Plaintiff has sufficiently pled that Mazars CPA’s statements that its
Audit Reports were PCAOB-compliant were materially false and misleading. Particularly with
regards to the GAAS requirements that an auditor (1) “assess audit risk and materiality.
.
.
in
determining the nature, timing and extent of audit procedures and in evaluating the results of those
procedures” and that (2) “in considering audit risk, ‘the auditor should specifically assess the
risk
of material misstatements of the financial statements due to fraud” (Compl. ¶30), Plainti
ff has
identified specific “red flags” which Defendant allegedly failed to take into consideration before
rendering an opinion on the reliability of Telestone’s financial statements. While identif
ied in
detail below, some of these red flags include, but are not limited to, the Company’s own admissions
that its internal controls were weak, that it had limited negotiating power with the Big and
3,
that
the Big 3 clients did not comply with the terms of Telestone’s contracts. Thus, Plaintiffhas
offered
the required “detailed set of allegations as to how [Mazars CPA] violated specific GAAS
standards
in its audit of [Telestone], and [as discussed below, he has] identified numerous
substantive
indicators of fraud that were allegedly ignored altogether in the auditing process.” Suprema,
438
F.3d at 280.
iv
Statements Regarding Telestone’s Internal Controls
In addition to the alleged misrepresentations discussed above, the Amended
Complaint
provides a fourth basis as to why Mazars CPA’s Audit Reports were false and
misleading—
20
specifically, because “Telestone’s internal controls were not effective but were instead
plagued by
significant material weaknesses.” Compi.
¶ 128).
Defendant responds that contrary to the Amended Complaint’s representations that
the
audit reports provided false assurances related to Telestone’s internal controls, Mazar
s CPA’s
Audit Reports expressly state that the auditors express no opinion on the Compa
ny’s internal
controls:
The Company is not required to have, nor were we engaged to perform, an audit
of its
internal control over financial reporting. Our audits included consideration of interna
l
control over financial reporting as a basis for designing auditing procedures that
are
appropriate in the circumstances, but not for the purpose of expressing an opinio
n on the
effectiveness of the Company s internal control overfinancial reporting. Accord
ingly, we
express no such opinion.
(Def’s. Mov. Br. at 21, Ex. I).
Because the Audit Reports expressly disclaim rendering an opinion on the effectiveness
of
the Company’s internal controls, the Court finds that Plaintiffs fourth alleged missta
tement is
insufficiently pled.
C. Plaintiff Has Sufficiently Plead Scienter as to Mazars CPA
Having found in part that the statements alleged in Plaintiffs Amended
Complaint are
materially false and misleading, the Court now addresses whether Plaintiff has
sufficiently pled
scienter as against Mazars CPA.
i.
Plaintiff’s Pleading of the “Collective Scienter”
Mazars CPA argues that Plaintiffhas failed to sufficiently plead scienter under
the PSLRA and
Rule 9(b)’s heightened pleading requirements. (Def’s. Mov. Br. at 22-35)
. As a preliminary
matter, Mazars CPA contends that Plaintiffimproperly relies on the “collec
tive scienter” of Mazars
CPA rather than pleading the scienter of “at least one individual officer who
21
made, or participated
in the making of a false or misleading statement,” as Mazars CPA contends is require
d. (DePs.
Mov, Br. at 15-16). Even if it were appropriate for Plaintiff to plead the collect
ive (or “corporate”)
scienter, Mazars CPA alleges that such pleading is only appropriate under
“extraordinary
circumstances” not found in the Amended Complaint. (Def’s. Mov. Br. at
16). Plaintiff does not
directly respond to the argument that it has improperly pled the “collective sciente
r.”
The circuits are split on the question of whether a plaintiff may meet the
strict pleading
requirements of the PSLRA by pleading the “collective” or “corporate” sciente
r. The Fifth Circuit,
for example, has held that plaintiffs must plead that at least one individual acting
on behalf of the
corporation made a false statement with the requisite state of mind. See Southl
and Securities Corp.
INSpire Ins. Solutions, Inc., 365 F.3d 353, 366-67 (5th Cir. 2004). By
contrast, the Second,
Sixth, Seventh, and Ninth Circuits have approved the viability of the collect
ive scienter doctrine
while nonetheless upholding the strict pleading requirements of the PSLRA. Teams
ters Local 445
Freight Div. Pension Fund v. Dynex Capital, 531 F.3d 190, 195 (2d Cir.
2008); City of Monroe
Employees Retirement Syst. v. Bridgestone Corp., 399 F.3d 651, 684,
689-90 (6th Cir. 2005);
Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702, 710 (7th Cir.
2008); Glazer Capital
Mngmt, LP v. Magistri, 549 F.3d 736, 744 (9th Cir. 2008).
While the Third Circuit has not definitively decided whether a plaintiff can
plead the collective
scienter with regards to PSLRA claims, it has indicated that it may be
possible to plead scienter
against a corporation without pleading scienter against an individ
9
ual.
City of Roseville
Employees’ Retirement Sys. v. Horizon Lines, Inc., 442 Fed. Appx. 672,
676-77 (3d Cir. 2011)
(unpublished); see also Rahman v. Kid Brands, Inc., 736 F.3d 237, 246
(3d Cir. 2013). Courts
Likewise, this Court has previously declined to hold that a plainti
ff in a Section 10(b) pleading may never meet the
scienter requirement by pleading the collective scienter. See Rahma
n v. Kid Brands, Inc., Civ. No. 11-1624, 2012
WL 762311 at * 17 (D.N.J. Mar. 8, 2012) (Linares, J.), aJJ’d 736 F.3d 237,
246 (3d Cir. 2013).
22
have found collective scienter to satisfy the pleading standard where “the pleaded facts
[1 create
a strong inference that someone whose intent could be imputed to the corporation acted
with the
requisite scienter.” Dynex, 531 F.3d at 195; see also Tellabs. 513 F.3d at 711 (stating
that where
a “dramatic announcement would have been approved by corporate officials
sufficiently
knowledgeable about the company to know that the announcement was false,” a “strong
inference
of corporate scienter” would arise).
Here, the Audit Reports containing the allegedly material false statements were signed
by
“Mazars CPA Limited” as an entity. (See Compl.
¶J 124-127). In fact, the Audit Reports do not
appear to be signed by a known, named individual auditor.’° However, given that
these Reports
were presumably approved by a senior auditor and for disclosure to the public in compl
iance with
financial reporting requirements, the Court finds that the pleaded facts and allegat
ions as to
scienter. discussed in detail below, “create a strong inference that someone whose intent
could be
imputed to the corporation acted with the requisite scienter.”
Dynex, 531 F.3d at 195.
Accordingly, the Court will not dismiss Plaintiff’s claims against Mazars CPA at the
juncture for
failing to plead scienter as to a specific individual related to the Defendant.
ii.
Legal Standard as to Outside Auditor Scienter
The Third Circuit has outlined the pleading standard relevant to an outside auditor
. See In re
Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256 (3d Cir. 2006). In Suprema,
the Circuit Court
reversed a district court’s finding that the plaintiff failed to plead scienter as to an
outside auditor.
438 F.3d 256 (3d Cir. 2006). The Court explained that “{wjhen a professional opinio
n is issued to
the investing public by those in a position to know more than the public, there is
an obligation to
°
At this stage of the litigation, and given that the Audit Reports
how Plaintiff would be able to identify any specific auditor.
23
were not signed by a specific auditor, it is unclear
disclose data indicating that the opinion may be doubtful.” Id. at 279 (citing Eisenberg v. Gagno
n,
766 R2d 770, 776 (3d Cir. 1985). The Court reiterated its previous holding that when
that
professional opinion is
based on underlying materials which on their face or under the circumstances sugges that
t
they cannot be relied on without further inquiry, then the failure to investigate further may
support[] an inference that when [the defendant] expressed the opinion it had no genuin
e
belief that it had the information on which it could predicate that opinion.
Id. (quoting Eisenberg, 766 F.2d at 776) (internal quotations omitted); see also Novak
v.
Kasaks, 216 F.3d 300, 308 (2d Cir. 2000) (“Under certain circumstances, we
have found
allegations of recklessness to be sufficient where plaintiffs alleged facts demonstratin
g that
defendants failed to review or check information that they had a duty to monitor, or
ignored
obvious signs of fraud.”).
To that end, the Circuit explained that a plaintiff pleading auditor scienter may allege
that (1)
“an auditor either lacked a genuine belief that its representations were supported
by adequate
infonnation,” (2) or, that the auditor “engaged in auditing practices so shoddy that they
amounted
at best to a ‘pretended audit.” Id. at 279; see also McLean v. Alexander, 599 F.2d 1190,
1198 (3d
Cir, 1979), However, a plaintiff is required to “show that [the auditor]’ s judgment the
at
moment
exercised was sufficiently egregious such that a reasonable accountant reviewing
the facts and
figures should have concluded that [the company’s] financial statements were missta
ted and that
as a result the public was likely to be misled.” Suprema, 438 F.3d at 279 (quotin
g In re Ikon, 277
F.3d at 673).
In Suprema, the Third Circuit noted that “[a]t the pleading stage, courts have recogn
ized that
allegations of GAAS violations, coupled with allegations that significant ‘red
flags’ were ignored,
can suffice to withstand a motion to dismiss.” Id. at 279-80 (citing to First and Fourth
Circuit case
24
law, as examples). “Such allegations, of course, must be pled with particularity.” Id. For examp
le,
the Third Circuit stated that if a plaintiff cites to violations of GAAS standards to suppor
t an
inference of scienter, the plaintiff must explain “how the defendant knowingly or reckles
sly
violated those standards.” Id. at 280 (citing In re Westinghouse Sec. Litig., 90 F.3d 696,
712 (3d
Cir. 1996)). As the Circuit previously noted, “in many cases, the most plausible means to prevail
on a section 10(b) claim against an auditor without that ever-elusive ‘smoking gun’ docum
ent or
admission will be to show how specific and not insignificant accounting violations collect
ively
raise an inference of scienter.” In re Ikon, 277 F.3d at 677 n. 26.
After outlining the standard to be applied to pleading outside auditor scienter, the Circui
t held
that the plaintiff raised sufficient inferences of auditor scienter to survive dismissal
where the
complaint explained how the auditors overlooked thirty “red flags” and also provided “a
detailed
set of allegations as to how [the auditors] violated specific GAAS standards in its
audit of [the
company].
Suprema, 438 F.3d at 280-81.
Ultimately, the Suprema Court found that such
allegations “surpass an inference of ordinary negligence; they reasonably suggest that
[defendant]
either knew of, or willfully turned a blind eye to, the fraud at [the Company].” Id. at 281.
Against this backdrop, the Court considers whether Plaintiff has sufficiently pled sciente
r as
to its auditor, Mazars CPA.
a. Plaintiffs Argument that Mazars CPA Conducted a “Pretended Audit”
Here, Plaintiff argues that the Amended Complaint satisfies the second, “shodd
y” audit basis
for alleging scienter as to an outside auditor. Suprema, 438 F.3d at 279. Specif
ically, Plaintiff
claims that Mazars CPA’s audit was so deficient that it amounted to no audit
at all. (P1’s. Opp.
Br. at 17-19).
In support of this argument, Plaintiff contends that “Mazars CPA’s failure
to
discover what was easily discoverable, despite several years of ‘audits,’ sugges
ts that for years
25
Mazars CPA merely rubber-stamped what Telestone’s management has told
it to.” (Id. at 18).
Moreover, Plaintiff maintains that where, as here, a meaningful audit would
have easily uncovered
the Company’s fraud, there is a strong inference of scienter. (Id. at 18).
In pleading auditor scienter, plaintiffs often direct the court to “red flags,” or
such “facts which
come to the attention of an auditor which would place a reasonable audito
r on notice that the
audited company was engaged in wrongdoing to the detriment of its investors.”
In re AOL Time
Warner, Inc. Sec. & ERISA Litig., 381 F Supp. 2d 192, 240 n. 51 (S.D.N
.Y. 2004) (quotations
omitted), And, as noted in Suprema, Courts similarly consider the extent
and seriousness of the
GAAP and GAAS violations alleged, as well as the severity of the alleged
fraud in determining
whether Plaintiff has made a sufficient inference of auditor scienter. See,
e.g., New Mexico State
Investment (‘ouncil v. Ernst & Young LLP, 641 F.3d 1089 (9th Cir. 2011)
(“[J]ust as with GAAP,
the more likely an auditor would have discovered the truth if a reasonable
audit had been
conducted, the stronger the inference of scienter.”); see also In re MicroStrategy
, Inc. Sec. Litig.,
115 F. Supp. 2d 620 (E.D. Va. 2000) (“[T]he less complex the rules violate
d, the greater the
magnitude of the irregularities, and the more frequent the violations, the
stronger is the inference
that conscious fraud or recklessness is the explanation for the auditor’s
role in the violations.”).
b. Red Flags
In his opposition brief, Plaintiff identifies nine “red flags” that he conten
ds would have put a
reasonable auditor on notice of potential fraud which, Mazars CPA alleged
ly failed to heed in its
audits,
(P1’s. Opp. Br. at 20-21). These “red flags” fall into the following three
categories: (1)
Telestone’s admissions in SEC correspondence; (2) Telestone’s
admissions in its Form 10-Ks
regarding the risks of doing business with the Big 3, and; (3) the Compa
ny’s increasing DSOs and
26
accounts receivables.
(Id.).
The Court considers each of these red flags, and Defendant’s
objections to same, in turn.
i.
SEC Correspondence and Form 10-Ks
The vast majority of the red flags cited to include admissions made by Telesto
ne through its
communications with the SEC, discussed above.
Specifically, Plaintiff cites to Telestone’s
admissions: that it had limited negotiating leverage and limited legal recour
se against the Big 3
clients (Compl.
¶J 4,
51); that these clients routinely ignored contractual terms; that Telesto
ne
granted payment concessions to the Big 3 (Id.
¶ 75), and; that as a result of customers following
their own payment processes, the Company’s days sales outstanding were
increasing (Id.
¶ 71).
Additionally, in Plaintiff’s opposition brief,-he cites to “red flags” contain
ed in Telestone’s
own Form 10-Ks published during the class period. (P1’s.
Opp.
Br. at 20).
These public
disclosures included similar admissions as those in the SEC filings. For examp
le, the Form 10-Ks
stated that the Company’s “disclosure controls and procedures were not
effective due to control
weaknesses and control deficiencies in our internal control over financial
reporting.” (Id.) (citing
to Def’s, Mov. Br. at 22). Additionally, under a heading labeled “Risks
Related to Our Business
and Operations,” Telestone stated that it “experiences delays in payme
nts” from the Big 3 and that
“these delays are largely due to our limited bargaining leverage and the
resulting lack
1
of a specific
Although Plaintiff’s Amended Complaint does not identify these
particular statements made in the Company’s
Form 10-Ks, this Court will nevertheless consider these statem
ents in its analysis because the Form 10-Ks are an
integral part of Plaintiff’s claims which are specifically referenced
in the Complaint, and because the authenticity of
these documents, which Defendant has attached to its Motion
to Dismiss, is not disputed. See, e.g., Tellabs, 551
U.S. at 322 (permitting a court ruling on a motion to dismiss to
consider matters of which it took judicial notice)
(citing 5B Wright & Miller § 1357 (3d ed. 2004 and Supp. 2007);
Mayer v. Belichick, 605 F.3d 223, 230 (3d Cir. 2010)
(“In deciding a Rule 12(b)(6) motion, a court must consider only
the complaint, exhibits attached to the complaint,
matters of public record, as well as undisputedly authentic docum
ents if the complainant’s claims are based upon
these documents.”); In re Burlington Coat Factory Sec. Litig., 114
F.3d 1410, 1426 (3d Cir. 1997) (“[A] document
integral to or explicitly relied upon in the complaint may be consid
ered without converting the motion to dismiss
into one for summary judgment.”) (quotations and citations omitte
d).
27
timetable in our sale and purchase contracts to require our custom
ers to issue completion
certificates and to perform preliminary inspections, which are pre-co
nditions to their initiation of
payments.” (Id.) (citing Def’s Mov. Br. at 33).
Defendant challenges the relevance of the SEC communications to
the scienter analysis.
Mazars CPA states that Telestone’s admissions during the SEC investigation
are not “red flags”
for purposes of raising inferences as to Mazars CPA’s knowledge
of fraud.
First, those
communications were only between Telestone and the SEC, and therefo
re knowledge of these “red
flags” cannot be imputed to Mazars CPA. (Def’s. Mov. Br. at 27). Second
ly, Defendant argues
that the SEC communications, the earliest of which is dated Septem
ber 24, 2012, post-date the
Audit Reports implicated in this action, and therefore say nothing of
Mazars CPA’s knowledge of
potential fraud at the time that it issued its Audit Reports containing
the alleged misstatements.
(Id, at 27). Defendant reiterates the Third Circuit’s statement in Suprem
a that the “plaintiff must
show that [the auditorj’s judgment at the moment exercised was suffici
ently egregious.
.
.
.“
Id.
(quoting Suprema, 438 F.3d at 279). Thus, Mazars CPA maintains that
the issue is whether there
is a detailed red flag allegation based on Mazars CPA’s knowledge
prior to March 30, 2012—the
date of the final Audit Report issued during the class period. (Id. at 26).
Mazars CPA also contends
that the SEC communications “establish a strong inference that Telesto
ne had
myriad reasons why
it thought each of the four factors for recognizing revenue were met”
and that “the only factual
allegations in the [Amended] Complaint about Mazars CPA’s beliefs
establish that Mazars CPA
did believe its representations were supported by adequate inform
ation.” (Id. at 27).
Mazars CPA also argues that “Telestone did not, as Plaintiff alleges
, make a secret of the fact
that the commercial realities of doing business with the ‘Big
3’ state-run telecommunications
business in China presented risks with regard to the timing, certain
ty, amount, and collectability
28
of certain payments.” (Def’s. Mov. Br. at 32). Defendant cites to the Compa
ny’s Form 10-Ks,
issued during the class period, as evidence that the same “red flags” identified
by Plaintiff in the
SEC communications had been disclosed to investors. (Id. at 32-35). Accord
ing to Defendant,
because these “red flags” were publicly disclosed, they cannot serve as a basis for
raising auditor
scienter, (Id.).
ii.
The Company’s Increasing DSOs and Accounts Receivables
In addition to citing to communications between the SEC and Telestone and
from Telestone to
its investors, Plaintiff states that the fact that the Company’s days sales outstan
ding period and
accounts receivables increased significantly during the class period were signifi
cant red flags that
the Big 3 were not held accountable for payments due on their contracts. (P1’s.
Opp. Br. at 20-21).
Defendant responds that these increased figured cannot be said to be “red
flags” indicating
that the Company’s customers did not intend to honor their contracts; rather,
Mazars CPA argues
that a review of these numbers during the years prior to the Class Period
demonstrates a similar
trend, which, according to Defendant, only indicates that such increases are
and had been “a reality
of Telestone’s business.” (Def’s. Mov. Br. at 29-31).
c. Additional Indicia of Scienter
In addition to Mazars CPA’s alleged failure to heed the “red flags” couple
d with the allegations
of GAAP and GAAS violations, the Amended Complaint includes
several other allegations
bearing on Mazars CPA’s allegedly reckless auditing practices.
Plaintiff suggests that an inference that Mazars CPA was aware of the
fraud can be made on
account of the “magnitude of the transactions at issue.” (Compi.
¶(
153-154). Specifically,
“[d]uring the Class Period, almost all of the Company’s purported revenu
e was derived from
29
business with the Big 3.” (Id.
¶ 154).
Thus, Plaintiff posits that “[fjrom the scale and obviousness
of the fraud—involving almost all of the Company’s revenue and where there were substantial
disclosed red flags—it can be inferred that either: (1) Mazars CPA actually knew of the fraud, in
which case its audit reports were knowingly false; or (2) Mazars CPA did not know of the fraud,
which only could happen as a result of audit procedures that were so sub-standard that the auditors
would have to have known they were sub-standard.” (P1’s.
Opp. Br. at 23).
The Amended Complaint also addresses the engagement history between Mazars CPA and the
Company. (Compi.
¶
150). Plaintiff allegess that Telestone engaged Mazars CPA as its outside
auditor through fiscal years ending December 31, 2007-2009. (Id.). On July 9, 2009, the Company
hired a different firm, QC CPA Group, LLC; however, that firm resigned on January 14, 2010.
(Id.). Only four days later, Telestone again engaged Mazars CPA to perform its audits. (Id.).
According to a Company representative, Mazars CPA was rehired because the Company “found
that this new auditor [QC CPA Group] was not as familiar with our business and changes some of
our ordinaries receivables as long term ones. Due to our high comfort level with our last time
auditor, we switched back to Mazars and has [sic] been working to our traditional approved method
of reporting receivables.” (Id.
¶
151).
Further, Plaintiff points to Telestone’s lack of adequate sales records and refusal to supply the
SEC with its sales contracts as additional evidence of a grossly deficient audit. (Compi.
158).
¶J
155-
Specifically, when, on June 26, 2013, the SEC requested, inter alia, “a schedule of
[Telestone’s] accounts receivable by year from January 1, 2009 through September
30, 2012,” the
Company’s initial response was that it was not permitted, under its non-disclosure agreements,
“to
release any data or material that may lead to the disclosure of customer information.” (Id.
¶
156).
Several months later, Telestone further responded to the SEC’s request by stating that it “has
30
organized a 10 person finance working group since early September and spent 2 month
s trying to”
comb through its project contracts to prepare a chart with the requested information.
(Id.
¶
157).
Based upon this response, Plaintiff contends that “[t]he fact that Telestone needed
ten people to
work two months to provide a simple chart containing the name of the customer,
the date of the
sales contract, the amount due and other contract terms, and the reason, if any, for non-pa
yment,
demonstrates that Mazars had completely negated its auditing responsibilities.”
(Id.
According to Plaintiff, the requested information was “so basic that the lack of it should
¶
158).
have been
a red flag that Mazars picked up on during its audit.” (Id.).
d. Discussion
Before the Court considers the above arguments for and against an inference of sciente
r, the
standard for sufficiently pleading scienter in PSLRA actions bears repeating. When
considering
the sufficiency of pleadings as to scienter, a court “is not to scrutinize each allegat
ion in isolation
but to assess all the allegations holistically.” Tellabs, 551 U.S. at 326. Further, a court
must also
consider ‘plausib1e, nonculpable explanations for the defendant’s conduct, as well
as inferences
favoring the plaintiff. The inference that the defendant acted with scienter need
not be irrefutable,
i.e., of the ‘smoking gun’ genre, or even the ‘most plausible of competing inferen
ces.” 551 U.S.
at 322-324, “In sum, the reviewing court must ask: When the allegations are accept
ed 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. The Third Circuit has held that a plainti
ff may meet the
scienter requirement as to an outsider auditor by “show[ingj that [the auditor
]’ s judgment at the
moment exercised was sufficiently egregious such that a reasonable accountant
reviewing the facts
and figures should have concluded that [the company’s] financial statements
were misstated and
31
that as a result the public was likely to be misled.” Suprema, 438 F.3d at 279 (quotin
g In re Ikon,
277 F.3d at 673).
Based on a review of the Amended Complaint and the parties’ arguments
as to the
sufficiency of the allegations therein, the Court finds that “all of the facts
alleged, taken
collectively, give rise to a strong inference of scienter” that is “at least as strong
as any opposing
inference” offered by Defendant. Tellabs, 551 U.S. at 322, 326; see also Ayaya 564
,
F.3d at 273.
Among other circumstantial evidence of Mazar’s CPA’s scienter, Plaintiff has
directed the Court
to: allegations of specific GAAP and GAAS violations which are supported by
specific allegations
of “red flags” that Mazars CPA failed to heed in conducted its audits. These “red
flags” include
the Company’s own admissions that doing business with its main clients, from whom
it retains the
vast majority of its business, was highly tenuous. Specifically, in its Form
10-Ks, Telestone
admitted that “it experience[s] delays in payments” from the Big 3, that it has “limite
d bargaining
leverage” with same, and that “enforceability of contracts in China, especially
with governmental
entities, is relatively uncertain.”
(Def’s. Mov. Br. at 32-34).
Despite these admissions by
Telestone, Plaintiff argues that Defendant failed to take the steps required
of an auditor to inquire
further into the financial health of its client.
The Court is unwilling to disregard these “red flags” merely because they
were publicly
disclosed, as Mazars CPA contends is required. Defendant has not directed
this Court to any case
law in the Third Circuit or elsewhere, nor is the Court aware of any cases, holdin
g that “red flags”
that are disclosed to the public cannot, as a matter of law, result in an inferen
ce of scienter) In
2
12
The case law Defendant cites does not stand for the general proposition
that public disclosures, ipso facto,
cannot serve as red flags of fraud that would give rise to an inference
of scienter. Rather, in both cases cited by
Defendant, the courts found that the claimed “red flags” did not support
an inference of scienter where the “red flags”
were plainly disclosed to the public, including investors and the SEC. and where
in spite of these disclosures, no one
discovered the fraudulent scheme. See Meridian Horizon Fund, LP v. KPMG
(Cayman), 487 Fed. App’x. 636, 641
32
fact, in Suprema, before reversing the district court’s finding that plaintiffs had not
sufficiently
pled auditor scienter, the Third Circuit identified a handful of the thirty “red flags” listed
in the
plaintiffs’ complaint, which included information that would have been available to
the public.
Suprema, 438 F.3d at 280 (identifying, among other “red flags”, the fact that “Supre
ma posted
growth that was radically disproportionate to the cheese industry as a whole” and that “[ajith
ough
Suprema was reporting rapid growth in production, it did not report corresponding increas
es in its
labor force and the utilization of its production facilities.”). Indeed, the Third Circui
t credited
these “red flags” as being among the “strong indicators” of auditor scienter. Id. Accord
ingly, the
Court finds Mazars CPA’s argument that these “red flags” are an inadequate indicia
of auditor
scienter on account of their publicized nature is without merit.
or is the Court persuaded by Defendant’s argument that the allegations of sciente
r are
materially weak. For example, while the Court agrees with Mazars CPA that the
inquiry should
revolve around the “red flags” available to Mazars CPA at the time that it issued
its Audit Reports,
and that Plaintiffs reliance on the SEC communications are problematic becaus
e, among other
issues, these admissions post-date those Reports, the Court finds that by Defend
ant’s own
representations, the same admissions were also made by Telestone in its Form 10-Ks,
which were
published contemporaneously with Mazars CPA’s Reports. Thus, it can be inferre
d, based on the
published Form 10-Ks, that the Company’s auditor was aware of its contents.
(2d Cir. July 10, 2012); In re Longtop Financial Tech. Ltd. Sec. Litig., 910 F.
Supp. 2d 561, 577 (S.D.N.Y. 2012).
For example, in Meridian Horizon Fund LP v. KPMG (C’ayman), an unpubl
ished case involving the Bernie Madoff
scheme, the Second Circuit agreed with the district court’s finding that “the more
compelling inference as to why
Madoff’s fraud went undetected for two decades was his proficiency in coverin
g up his scheme and deceiving the
SEC and other fmancial professionals.” 487 Fed. App’x at 640-41. Likewise,
in In re Longtop Financial Tech. Ltd.
Sec. Litig.. the Southern District of New York stated that, “despite the disclos
ure. neither the SEC nor the investing
public recognized Longtop’s alleged fraud.” 910 F. Supp. 2d at 577.
.
33
.
The Court is also cognizant of Defendant’s position that there are no
allegations that
Mazars CPA lacked a genuine belief that its statements were truthful.
(Def’s. Mov. Br. at 26).
However, because Plaintiff’s theory of scienter is premised upon the “shodd
y audit” theory, he is
not required to show that Mazars CPA acted in bad faith in preparing
its Audit Reports. See
Suprema, 438 F.3d at 279 (“A showing that an auditor either lacked
a genuine belief that its
representations were supported by adequate information or engage
d in auditing practices so
shoddy that they amounted at best to a ‘pretended audit’ has traditionally
supported a finding of
liability, even in the face of assertions of good faith.”) (emphasis added)
. In any event, Defendant
points to meeting minutes included in the SEC correspondence incorporated
into the Amended
Complaint, stating that “Mazars believes that Telestone’s revenue recogn
ition practices were
consistent with GAAP and that the Company should be able to recognize
on an ‘accrual basis’ and
not on a ‘cash basis’ as requested by the SEC.” (Def’s. Mov. Br. at 27-28)
(citing Compl.
Defendant also contends that the lengthy back-and-forth between Telesto
ne and the SEC,
¶ 56).
in which
Telestone explained why it believed its revenue was properly recogn
ized, demonstrates that the
Company itself acted in good-faith in its financial reporting. (Id. at
27). As Mazars CPA itself
explains, these communications, including the meeting minutes
dated March 13, 2013, are not
relevant to the issue of its scienter, or, more specifically, whether
it acted recklessly in issuing
clean audit reports, because they post-date the Audit Reports in questio
n.
Lastly, while the Court recognizes Defendant’s position that the
increases in DSOs and
accounts receivables do not raise an inference of wrongdoing,
but rather are a part of the
Company’s business, the Court finds that Plaintiff’s analysis of these
numbers as indicative of the
Big 3’s unwillingness to satisfy its contractual obligations is an
equally compelling argument
giving rise to scienter.
34
[n sum, at this stage in the litigation, Plaintiff’s securities fraud claim against Mazar
s CPA
survives dismissal. Plaintiff has sufficiently pled scienter as to the auditing firm by
identifying:
(1) allegedly suspect increases in accounts receivables and DSOs; (2) specifi
c “red flags” the
Plaintiff argues Mazars CPA had a duty to explore prior to issuing clean audit reports
; (3) specific
GAAS and GAAP violations; (4) and additional circumstantial evidence that Mazars CPA
was not
fulfilling its due-diligence in its audits of Telestone.
D. Plaintiff Has Not Affirmatively Pled Himself out of Court on Statute of Limita
tions
Grounds
A securities fraud claim is timely if it is filed by the earlier of”(1) 2 years after the
discovery
of the facts constituting the violation; or (2) 5 years after such violation
“
28 U.S.C.
§
l658(b)(l). Courts determine the onset of the statute of limitations period in one
of two ways:
“(1) when the plaintiff did in fact discover, or (2) when a reasonably diligent plainti
ff would have
discovered, ‘the facts constituting the violation’—whichever comes first.” Pensio
n Tr. Fund for
Operating Eng ‘rs v, Mortg. Asset Securitization Transactions, Inc., 730 F.3d
263, 273 (3d Cir.
2013) (quoting Merck & Co., Inc. v. Reynolds, 559 U.S. 633, 637 (2010)). In
regards to a securities
action filed pursuant to Section 10(b), the Supreme Court has held that “the ‘facts
constituting the
violation’ include the fact of scienter, ‘a mental state embracing intent to deceiv
e, manipulate, or
defraud.” Merck, 559 U.S. at 637 (quoting Ernst & Ernst v. Hochfelder, 425
U.S. 185, 194 n. 12
(1976)).
Mazars CPA argues that Plaintiffs claim is time-barred because Plaintiff had
discovered the
underlying alleged fraud prior to February 2, 2013—over two years prior to
the February 2, 2015
initiation of this action.
(Def’s. Mov. Br. at 36-40).
Specifically, Defendant notes that the
information disclosed in the Company’s 2012 Quarterly Announcements
relating to the increase
in the Company’s DSOs and accounts receivable support Plaintiffs claims
of loss causation as
35
well as scienter. (Def’s. Mov. Br. at 36). Thus, Defendant alleges that these
2012 disclosures, in
addition to a 2011 investigation by Plaintiffs attorneys’ law firm, suggest that
Plaintiff discovered
the relevant facts well over two years prior to the initiation of this action.
(Id.). Further, Mazars
CPA contends that Plaintiffs claim that the full truth of the Company’s financi
al health was not
revealed until the February 19, 2014 publication of the SEC communications is unavai
ling in light
of Plaintiffs alleged failure to “identify any facts revealed in the SEC corresp
ondence that were
not previously known.” (Defs. Reply Br. at 14).
Plaintiff maintains that the statute of limitations did not begin to run until
the February 2014
publication of the SEC communications because “a reasonably diligent investo
r would have had
no reason to believe that fraud on the part of Telestone was probable, and not merely
possible” on
account of Mazars CPA’s assurances that the Company’s revenue recognition
was in accordance
with GAAP. (P1’s
Opp.
Br. at 28). Alternatively, Plaintiff suggests that April 17, 2013, could
have been “the first date that information regarding the falsity of Telestone’
s financial condition
was revealed when the Company disclosed that it was not able to obtain certain
necessary financial
records needed to complete the Company’s audit.” (Id. at n. 21). Notably,
this is the same date
that the Company was delisted from NASDAQ, and therefore the cut-off date
for the class-period.
A motion to dismiss on statute of limitations grounds should be denied unless
it is apparent
from the face of the complaint that the claims are time-barred. See Barefo
ot Architect, Inc. v.
Bunge, 632 F.3d 822, 835 (3d Cir. 2011); see also Schmidt v. Skolas
, 770 F.3d 241, 251 (3d Cir.
2014) (“Pursuant to application of the discovery rule, the point at which
the complaining party
should reasonably be aware that he has suffered an injury is a factual issue
‘best determined by the
collective judgment, wisdom and experience of jurors.”) (quotations and
citations omitted). As
the Third Circuit has recently stated with respect to the discovery rule:
36
[W]hile a court may entertain a motion to dismiss on statute of limitations ground
s, it may
not allocate the burden of invoking the discovery rule in a way that is incons
istent with the
rule that a plaintiff is not required to plead, in a complaint, facts sufficient to overco
me an
affirmative defense. This distinction comes to the fore here, where the applica
bility of the
discovery rule is not evident on the face of the complaint but the plainti
ff also does not
plead facts that unequivocally show that the discovery rule does not apply.
Schmidt v. Skolas, 770 F.3d 241,251 (3d. Cir. 2014) (internal citations omitte
d) (finding the district
court erred in requiring plaintiff to “affirmatively show that he exercised
‘reasonable diligence’
with respect to discovering his injury” at the motion to dismiss stage). Stated
differently, “[i]f the
[statute of limitations] bar is not apparent on the face of the complaint, then
it may not afford the
basis for a dismissal of the complaint under Rule 12(b)(6).” Bethel v. Jendoc
o Constr. Corp., 570
F.2d 1168, 1174 (3d Cir. 1978).
In light of this standard, the Court finds that Plaintiff has not pled himsel
f out of court
because his allegations do not affirmatively demonstrate on the face of
the Amended Complaint
that his claims are necessarily time-barred. Rather, there remains a factual
dispute as to the date
that Plaintiff discovered or could have discovered the fraudulent conduc
t alleged, and the Court
may “not allocate the burden of invoking the discovery rule in a way that
is inconsistent with the
rule that a plaintiff is not required to plead, in a complaint, facts
sufficient to overcome an
affirmative defense.” Schmidt, 770 F.3d at 251. Accordingly, the Court will
not dismiss Plaintiff’s
claims as time-barred at this time.
CONCLUSION
For the reasons stated herein, Mazars CPA’s motion to dismiss Plainti
ff’ Amended Complaint
is hereby denied. An appropriate Order accompanies this Opinio
n.
37
IT IS SO ORDERED.
DATED: December
,
2015
JOWL. INARES
L$4TED STATES DISTRICT JUDGE
38
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