Faris et al v. Longtop Financial Technologies Limited et al
Filing
150
OPINION AND ORDER: For the foregoing reasons, defendant DTTC's motion to dismiss is granted. The Clerk of Court is directed to close this motion (Docket No. 128). (Signed by Judge Shira A. Scheindlin on 4/8/2013) (cd)
UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
---------~----------------------x
IN RE LONGTOP FINANCIAL
TECHNOLOGIES LIMITED
SECURITIES LITIGATION
OPINION AND ORDER
11 Civ. 3658
,. ,--~
--------------------------------- X
SHIRA A. SCHEINDLIN, U.S.D.J.:
I.
INTRODUCTION
Lead plaintiffs Danske Invest Management A/S and Pension Funds of
Local No. One, LA.T.S.E. (collectively, "Lead Plaintiffs"), as well as additional
plaintiff Pompano Beach General Retirement System (together with Lead
Plaintiffs, "Plaintiffs"), bring this putative class action on behalf of themselves and
others similarly situated (the "Class") against Longtop Financial Technologies,
Ltd. ("Longtop"), its former director and CEO Weizhou Lian a/k/a Wai Chau, its
former CFO Derek Palaschuk (together with Weizhou Lian, the "Individual
Defendants"), and its auditor Deloitte Touche Tohmatsu CPA Ltd. ("DTTC"). The
Class consists of all persons and entities who purchased American Depositary
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.1
\
Shares (“ADSs”) of Longtop Financial Technologies, Ltd. on the New York Stock
Exchange (“NYSE”) during the period October 24, 2007 through May 17, 2011,
inclusive (the “Class Period”), and who were allegedly damaged thereby. Lead
Plaintiffs assert three causes of action for: violation of Section 10(b) of the
Exchange Act and Rule 10b-5 promulgated thereunder against Longtop and the
Individual Defendants (Count One); violation of Exchange Act Section 20(a)
against the Individual Defendants (Count Two); and violation of Section 10(b) and
Rule 10b-5 against DTTC (Count Three).
Previously, DTTC successfully moved to dismiss Count Three of the
Consolidated Class Action Complaint (“CAC”) for failure to state a claim. Lead
Plaintiffs subsequently filed the Amended Consolidated Class Action Complaint
(the “Amended Complaint”), using discovery obtained from Palaschuk, who had
unsuccessfully moved to dismiss prior to DTTC’s appearance in the case. At a
hearing held on January 8, 2013, DTTC orally moved to dismiss the Amended
Complaint on the basis that the use of discovery to support the Amended
Complaint violates the Private Securities Litigation Reform Act of 1995
(“PSLRA”) stay of discovery, and I denied this motion.1 Presently before the
Court is DTTC’s motion to dismiss the Amended Complaint under Federal Rule of
1
See 1/8/13 Hearing Transcript (“Hr’g Tr.”) at 6:11-24:23.
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Civil Procedure (“Rule”) 12(b)(6). For the following reasons, the motion is
granted.
II.
BACKGROUND
A.
Procedural Posture
I issued an Opinion and Order (the “Dismissal Opinion”) granting
DTTC’s motion to dismiss Count Three of the CAC on November 14, 2012.2 The
Dismissal Opinion rested on the grounds that the CAC failed to adequately allege:
(1) scienter on the part of DTTC;3 and (2) that DTTC’s Class Period audit opinions
contained material misrepresentations of fact, i.e., statements “grounded on a
specific factual premise that is false, and that [DTTC] did not ‘genuinely or
reasonably believe . . . .’”4 Lead Plaintiffs were granted leave to amend within
thirty days of the Order,5 and subsequently filed the Amended Complaint, which
draws support from documents that Lead Plaintiffs received in response to
discovery requests served on Palaschuk.6
2
See In re Longtop Fin. Techs. Ltd. Secs. Litig., No. 11 Civ. 3658, 2012
WL 5512176 (S.D.N.Y. Nov. 14, 2012).
3
See id. at *9.
4
Id. at *10 (quoting In re International Bus. Mach. Corp. Secs. Litig.,
163 F.3d 102, 107 (2d Cir. 1998)).
5
Id.
6
See 1/8/13 Hr’g Tr. at 38:15-39:23.
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B.
Summary of Facts Re-Alleged in the Amended Complaint
This section summarizes factual allegations common to the Amended
Complaint and the CAC. These facts were previously described in the Dismissal
Opinion,7 and are presumed to be true for the purposes of this motion.
Claim Three of the CAC charged DTTC with violating Section 10(b)
and Rule 10b-5 by issuing unqualified audit opinions on behalf of Longtop
between June 29, 2009 and May 17, 2011. During this period, Longtop reported
very strong financial results, but these results were inflated by its fraud. Longtop’s
fraudulent actions included hiring its employees through a shell company, Xiamen
Longtop Human Resources (“XLHRS”), in order to hide its true cost of revenue;
falsifying its cash position and bank loan balances by manipulating its bank
records; and interfering with DTTC’s audits.
Beginning on April 26, 2011, Longtop’s fraud began to unravel as
short-sellers began issuing reports calling Longtop’s financial results into question.
On May 23, 2011, Longtop announced that DTTC had resigned as its outside
auditor. That same day, DTTC released to the public a letter (the “Resignation
Letter”) revealing that DTTC’s attempt to conduct a second round of bank
7
See In re Longtop, 2012 WL 5512176, at *1-3. Familiarity with the
Dismissal Opinion is presumed, including its use of short forms to refer to
accounting concepts and entities such as the PCAOB.
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confirmations at Longtop had been cut short by Longtop’s deliberate interference.
The Resignation Letter further stated that Longtop’s CEO had admitted that
Longtop’s books were fraudulent, and that DTTC had resigned due to this
admission and Longtop’s deliberate interference with its audit. The letter
concluded by suggesting that Longtop investigate its liability under the securities
laws. Subsequently, the NYSE halted trading on Longtop’s ADSs on May 27,
2011, began delisting proceedings against Longtop on July 22, 2011, and delisted
Longtop on August 29, 2011.
C.
New Facts Alleged in the Amended Complaint
The Amended Complaint lengthens the class period alleged in the
CAC by including allegations relating to two additional audit opinions by DTTC.
The Amended Complaint also adds four categories of substantive allegations to the
CAC, concerning: (1) internal control deficiencies and risk factors at Longtop; (2)
confirmation of revenue contract terms; (3) information DTTC received from third
parties; and (4) XLHRS and Longtop’s social welfare payments. These additions
to the CAC are summarized below.
1.
Extended Class Period
The Amended Complaint adds allegations based on audit opinions of
DTTC’s that were publicized on October 24, 2007 and July 1, 2008, thereby
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lengthening the class period.8 Count Three of the Amended Complaint therefore
rests on audit opinions issued by DTTC in connection with: (1) Longtop’s October
24, 2007 SEC Rule 424(b)(4) prospectus, issued in connection with its initial
public offering;9 (2) Longtop’s 2008 Form 20-F, issued on July 1;10 (3) Longtop’s
2009 Form 20-F, issued July 29;11 (4) Longtop’s November 17, 2009 secondary
offering;12 and (5) Longtop’s 2010 Form 20-F, issued on July 16.13
The circumstances surrounding the October 2007 audit opinion are as
follows. In preparation for Longtop’s U.S. IPO, DTTC was engaged in 2006 to
audit the consolidated financial results that Longtop had reported, under the
Chinese version of GAAP, for the years 2004-2006 and for the three month period
ending in March 31, 2007.14 Longtop’s October 24, 2007 Rule 424(b)(4)
prospectus incorporated the results of this audit, including statements by DTTC
8
See Amended Consolidated Class Action Complaint (“Am. Compl.”)
¶¶ 10, 33, 40, 95-103, 111, 140, 162-165, 173, 175-176.
9
See id. at ¶¶ 162-163.
10
See id. ¶¶ 172-173.
11
See id. ¶¶ 189-190.
12
See id. ¶ 202.
13
See id. ¶¶ 213-215.
14
See id. ¶ 163.
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that “‘[it] conducted [its] audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States) [(“PCAOB”)][;]’” and that
Longtop’s “‘consolidated financial statements present fairly, in all material
respects, [its] financial position . . . as of December 31, 2006 and 2006 and March
31, 2007, in conformity with [United States GAAP.]’”15 The prospectus also
quoted DTTC stating that: “‘[Longtop] is not required to have, nor were we
engaged to perform, an audit of its internal control over financial reporting . . . .’”16
2.
New Substantive Allegations
a.
Internal Control Deficiencies and Risk Factors
Plaintiffs alleges that DTTC was aware of internal control deficiencies
at Longtop at least as early as 2007, and of “red flags at Longtop that gave rise to a
significant risk of management fraud” at least as early as May 2008,17 but that
DTTC nevertheless issued audit opinions on March 31, 2009 and 2010 stating that,
in its opinion, Longtop had “‘maintained, in all material respects, effective internal
control over its financial reporting.’”18 The Amended Complaint supports these
15
Id. (quoting 10/24/07 Longtop SEC Rule 424(b)(4) Prospectus).
16
Id.
17
Id. ¶ 95.
18
Id. ¶ 97 (quoting Longtop 2009 and 2010 Forms 20-F). See id. ¶¶ 95-
106.
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allegations with references to the following documents: (1) an agenda for a May
29, 2007 meeting with Longtop’s audit committee at DTTC’s offices; (2) draft
meeting minutes for a November 15, 2007 Longtop Audit Committee meeting at
DTTC’s offices; (3-4) management letters prepared by DTTC to be sent to
Longtop’s Board of Directors, dated June 29 and August 2, 2007; (5) the draft
minutes of a February 20, 2008 meeting between Longtop’s Audit Committee and
DTTC; (6) a presentation that DTTC made to Longtop on May 26, 2008; (7) a
presentation that DTTC made to Longtop on May 26, 2009; and (8) a presentation
that DTTC made to Longtop on August 12, 2010.19
The first four of these documents arose out of the auditing work that
DTTC performed in advance of Longtop’s U.S. IPO. Plaintiffs allege that the May
29, 2007 meeting agenda states that “‘[m]aterial weaknesses/significant
deficiencies may exist’ within Longtop’s internal controls[,]” and that “‘Deloitte
will provide [a] management letter’” explaining these potential deficiencies.20 It
further alleges that the November 15, 2007 draft meeting minutes state that
“‘[m]aterial weaknesses/significant deficiencies may exist and a lot of work is
19
See id.
20
Id. ¶ 99 (quoting 5/29/07 Longtop Audit Committee Meeting
Agenda).
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required.’”21 Finally, the June 29 and August 2, 2007 management letters prepared
by DTTC to be sent to Longtop’s Board of Directors state that DTTC had
“‘considered [Longtop’s] internal controls over financial reporting as a basis for
designating audit procedures that are appropriate in the circumstances[,]” and, after
this review, had identified “certain matters involving [Longtop’s] internal control
over financial reporting that [DTTC] consider[ed] to be material weaknesses or
significant deficiencies under standards established by the PCAOB[,]” as well as
“other control deficiencies involving [Longtop’s] internal control over financial
reporting as of March 31, 2007.”22
Plaintiffs allege that, as of Longtop’s IPO, DTTC knew of a risk of
management override and of problems with Longtop’s reporting department, but
that “nothing was done to alert the investing public of these deficiencies.”23
However, the Form F-1 filed by Longtop on October 2, 2007 discloses that
Longtop was a privately held company, with “limited accounting personnel” prior
to its IPO, and that DTTC had identified a “material weakness for 2006[,]” and a
21
Id. (quoting 11/15/07 Longtop Audit Committee Meeting Minutes).
22
8/2/07 Letter from DTTC to Longtop Board of Directors (cited in Am.
Compl. ¶ 100), Ex. C to 1/25/13 Declaration of Elizabeth L. Howe in Support of
Deloitte Touche Tohmatsu CPA Ltd.’s Motion to Dismiss (“Howe Decl.”), at 1.
23
Am. Compl. ¶ 102.
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“significant deficiency and a large number of other deficiencies in [Longtop’s]
internal controls” for 2006 and the three months ending in March 31, 2007.24
The remaining documents referenced in this portion of the Amended
Complaint were created after Longtop’s IPO. Plaintiffs allege that the phrase
“[m]aterial weaknesses/significant deficiencies may exist and a lot of work is
required[,]” is repeated in the draft minutes of the February 20, 2008 meeting, and
that these minutes also state that “[s]ignificant work [is] required in [Longtop’s]
corporate reporting department.”25 It further alleges that DTTC’s May 26, 2008
presentation states that Longtop was “under significant pressure of [sic]
profitability or trend level expectations of [sic] . . . external parties (particularly
24
10/2/07 Longtop Form F-1, Prospectus, Ex. C to 1/25/13 Declaration
of Gazeena K. Soni in Support of Defendant DTTC’s Motion to Dismiss (“Soni
Decl.”), at 21. I take judicial notice of the full contents of this SEC filing, which
partially forms the basis for the Amended Complaint’s claim under the Exchange
Act. For similar reasons, I also take judicial notice of the other documents quoted
or referenced in the Amended Complaint that bear on the veracity of the statements
that DTTC made in documents publicly filed with the SEC. See In re Morgan
Stanley Info. Fund Secs. Litig., 592 F.3d 347, 355 & 355 n.1 (2d Cir. 2010)
(citations omitted). See also Kramer v. Time Warner Inc., 937 F.2d 767, 774 (2d
Cir. 1991) (“[A] district court may take judicial notice of the contents of relevant
public disclosure documents required to be filed with the SEC as facts ‘capable of
accurate and ready determination by resort to sources whose accuracy cannot
reasonably be questioned.’ This of course includes related documents that bear on
the adequacy of the disclosure as well as documents actually alleged to contain
inadequate or misleading statements.”) (quoting Fed. R. Evid. 201(b)(2)).
25
Am. Compl. ¶ 101 (quotation marks omitted) (alterations in original).
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expectations that are unduly aggressive or unrealistic), including expectations
created by management[,]”26 as well as stating that Longtop’s “current internal
controls may not meet the evolving demands in business, . . . caus[ing] additional
management and control risk for [Longtop],” including the “potential risk of
management override of control.”27
Plaintiffs allege that in a follow-up presentation, dated May 26, 2009
and titled “Longtop Technologies Limited [Sarbanes-Oxley (“SarBox”)] 404
Attestation Status Update,” DTTC noted that its planned response to the audit risks
that it had identified at Longtop would be to “[i]ncrease professional skepticism of
all personnel involved in the audit engagement.”28 It further alleges that, despite
this planned response, in an August 12, 2010 presentation titled “[Fiscal Year]
2011 Client Service Plan,” DTTC identified the same internal control deficiencies
and risk factors, and noted that it intended to “perform a test of internal controls or
substantive procedures . . . .”29 On the basis of these facts, the Amended
Complaint alleges that DTTC “should have issued an adverse opinion on
26
Id. ¶ 95 (quotation marks omitted) (emphasis removed).
27
Id. ¶ 96 (quotation marks omitted).
28
Id. ¶¶ 103-104.
29
Id. ¶ 104.
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Longtop’s internal controls over financial reporting as of March 31, 2009 and
2010, communicated that material weaknesses existed in Longtop’s internal
controls, and informed investors that the Company’s internal control over financial
reporting was not effective.”30
b.
Confirmation of Revenue Contract Terms
The second category of new allegations in the Amended Complaint
relates to DTTC’s failure to confirm the terms of Longtop’s major revenue
contracts. As an initial matter, the Amended Complaint notes that the August 2
and June 19, 2007 letters that DTTC sent to Longtop stated that “[b]ank
reconciliation procedures and review . . . were not documented as part of the
accounts closing process[,]” and recommended that “[b]ank reconciliation
statements should be prepared and reviewed by an independent supervisor on a
timely basis to ensure that cash items are properly recorded.”31
Plaintiffs then allege that in April 2009, a Longtop officer informed a
DTTC employee that obtaining direct confirmation of Longtop’s major revenue
contracts would unduly delay the filing of Longtop’s Form 20-F for the fiscal year
30
Id. ¶ 106.
31
Id. ¶ 111 (quotation marks omitted) (alterations in original).
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ending March 31, 2009.32 After a back-and-forth between the Longtop officer,
Palaschuk, and the DTTC auditor, during which the DTTC auditor initially insisted
that “confirmation is a required procedure[,]” the DTTC auditor eventually
acceded to Longtop’s request that the revenue contracts be confirmed through
alternate revenue testing.33
Plaintiffs allege that, had DTTC insisted on directly confirming the
revenue contracts, it would have discovered Longtop’s fraud.34 It supports this
allegation with reference to a series of e-mails sent by Palaschuk to Longtop’s
CEO in 2008, in which Palaschuk states that “Longtop has a culture where they
book accounting entries without contracts, which I have never seen [] in a
company[,]” and further states that Longtop’s accountants “rely upon [invoices]
and hand written descriptions” rather than actual contracts in booking revenues,
despite the fact that those “documents [could easily] be forged.”35
c.
Information from Third Parties
32
See id. ¶ 115.
33
See id. ¶¶ 115-119.
34
See id. ¶ 123.
35
Id. (quotation marks omitted) (alterations in original).
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The third category of new allegations in the Amended Complaint
relates to three instances where information which allegedly should have put
DTTC on notice of Longtop’s fraud was brought to DTTC’s attention by third
parties.36 First, the Amended Complaint alleges that Wedge Partners, a U.S. equity
analyst, published three reports (the “Wedge Reports”) on February 4, February
11, and March 23, 2010, calling into question Longtop’s staffing arrangement with
XLHRS.37
Second, Plaintiffs allege that in October 2010 — several months after
the publication of Longtop’s 2010 Form 20-F, containing the final Class Period
statement made by DTTC — partners in DTTC’s Beijing office met with the CFO
of YTEC, one of Longtop’s chief competitors and a company which had long
accused Longtop of over-reporting revenue.38 At this meeting, YTEC’s CFO
allegedly informed DTTC’s Beijing partners of potential improprieties at Longtop,
whereupon the Beijing partners informed DTTC’s Shanghai branch, which was
tasked with auditing Longtop.39 The Amended Complaint further alleges that an
36
See id. ¶¶ 124-132.
37
See id. ¶¶ 125-127.
38
See id. ¶ 128.
39
See id.
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audit partner at DTTC subsequently told Palaschuk that, because the matter was
discussed by DTTC’s Beijing Partners, it was “very high profile,” and as such,
DTTC had to perform “additional [audit] procedures.”40
Third, Plaintiffs allege that on November 2, 2010, a meeting was held
between Longtop and DTTC, and that the meeting minutes reveal that the purpose
of the meeting was to discuss “market rumors” that had been brought to Longtop’s
attention.41 These rumors included questions as to Longtop’s above market
margins, its use of XLHRS, and whether its software development revenue from
China Construction Bank (“CCB”) was overstated.42
Regarding CCB, the meeting minutes state that “[a] person at CCB
had questioned Longtop’s more than US$30 million in 2010 fiscal revenue from
CCB and said the number was closer to ‘Rmb30 million,’ Longtop has no
standardized software contracts with CCB and that Longtop was not an approved
vendor at CCB.”43 The minutes go on to state that Longtop had arranged for
analysts concerned about its relationship with CCB to meet with “CCB people in
40
Id. (quotation marks omitted) (alterations in original).
41
Id. ¶ 129 (quotation marks omitted).
42
See id.
43
Minutes from Meeting with [DTTC] on Nov[ember] 2, 2010 at
Longtop Xiamen Office (“11/2/10 Meeting Minutes”), Ex. M to Howe Decl., at
0107689.
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the Beijing development center,” and concludes that “[f]rom an investor relations
point of view, as these allegations are untrue, they will work themselves out.”44
Plaintiffs allege that at the meeting, DTTC suggested that Longtop
hire an independent consultant to investigate Longtop’s revenues from CCB, but
that Longtop rejected the suggestion.45 The meeting minutes reveal that DTTC
made this suggestion despite the fact that it had “seen no indications of fraud or
that Longtop’s revenue from CCB is inaccurate[,]” and that Longtop stated that it
“would confirm with . . . legal counsel whether . . . an investigation was
necessary.”46
Regarding XLHRS, the minutes state that:
Deloitte was aware of questions in the market over Longtop’s use
of third party outsourcing companies and that Longtop had held
a conference call with investors in March 2010 to address this
issue. There were no accounting issues as this structure had been
used for almost 4 years, is supported by legal opinions, disclosed
in the 20F and the agreements are on file with the SEC. No
followup required.47
44
Id.
45
See Am. Compl. ¶ 130.
46
11/2/10 Meeting Minutes at 107690.
47
Id.
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Finally, the minutes state that, at the meeting, Longtop’s management
gave a number of explanations for Longtop’s above-market margins, including,
e.g., “[a] comprehensive high quality solution offering and a wide customer base
allowing the efficient cross selling of solutions[,]” heavy use of modular,
proprietary intellectual property, and a back-office in Xiamen (which was cheap
relative to Beijing).48 Based on these explanations, the meeting minutes state that
no follow-up was required regarding Longtop’s above-market margins.49
d.
Welfare Payments
The fourth category of new allegations against DTTC in the Amended
Complaint relates to Longtop’s underpayment of its welfare obligations.50 The
upshot of these allegations is that DTTC was aware that Longtop was using
XLHRS to evade paying its employee welfare obligations under Chinese law, and
that it was therefore reckless for not investigating further and ferreting out
XLHRS’s alleged role in Longtop’s fraud.51 (In addition, the Amended Complaint
48
Id. at 107691.
49
Id.
50
See Am. Compl. ¶¶ 133-161.
51
See id. ¶ 160 (“Given DTT[C]’s awareness of significant red flags
suggesting that Longtop was seeking to use XLHRS to . . . evade its governmentmandated welfare obligations, DTT[C]’s failure to undertake any meaningful
investigation with respect to these interrelated party transactions with XLHRS . . .
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repeats the allegation of the CAC that DTTC was reckless in stating that XLHRS
and Longtop were not related parties in audit opinions incorporated in Longtop’s
2008, 2009, and 2010 Forms 20-F).52
Plaintiffs allege that DTTC knew that Longtop had underpaid its
social welfare obligations at least as early as 2007.53 It supports this allegation
with reference to the agenda prepared for a May 29, 2007 meeting between DTTC
and Longtop.54 This agenda reveals that Longtop had based its level of welfare
payments for the years 2004-2006 — prior to the Class Period — on its
interpretation of welfare law, and that, on the basis of this interpretation, it had
made welfare payments of $475,000, while accruing a liability of $1,258,000 for
its “maximum potential welfare payment[] . . . .”55 The agenda further notes that
Longtop had transferred approximately eight hundred employment contracts to
XLHRS, but had not “accrued for interest or penalties on the basis [that] the
likelihood is remote and the amounts are unknown.”56
was, at the very least, reckless.”).
52
See id. ¶ 133.
53
See id. ¶ 140.
54
See id.
55
Id.
56
Id.
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Plaintiffs further allege that, in a memo to file dated July 28, 2008, a
Longtop officer noted that Longtop had underpaid its welfare obligations in fiscal
years 2004 through 2006, but had accrued additional expenses in case of an
investigation by the Chinese government.57 This accrued liability was to be written
off if a government investigation failed to arise within five years.58 The Amended
Complaint does not allege that DTTC was aware of this memo during the Class
Period.
Plaintiffs then allege that in an April 8, 2010 e-mail, Palaschuk
inquired of DTTC whether it would be permissible under U.S. GAAP for Longtop,
in calculating its 2011 budget, to use the city average salary, rather than the
employee’s actual salary.59 Palaschuk’s e-mail further stated that, in practice, most
Chinese companies used city average salary rather than actual salary.60 An auditor
at DTTC replied that, under Xiamen’s social welfare regulations, actual salary
must be used unless the employee’s average monthly salary is less than sixty
percent of, or over three hundred percent of, the city average.61
57
See id. ¶ 141.
58
See id.
59
See id. ¶ 142.
60
See id.
61
See id.
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Plaintiffs allege that Palaschuk sent an e-mail to DTTC on December
8, 2010, stating that Longtop’s welfare payment practices passed the “smell test”
because they were similar to those of DTTC’s other clients.62 Based on meeting
minutes, Plaintiffs further allege that on December 13, 2010, DTTC and Longtop
met and discussed “ways to reduce Longtop’s average welfare rate . . . .”63 It also
alleges that a redlined draft of these meeting minutes shows that two entries were
initially included within, but eventually deleted from, the meeting minutes: (1)
“DTTC internally to review” Longtop’s assertion that its welfare payments met the
“smell test”; and (2) “Longtop to check whether feasible to have a clean certificate
from the social welfare bureau with regard to historical welfare payments.”64
Plaintiffs alleges that during this period, DTTC asked probing
questions about Longtop’s welfare payment scheme. For example, around the time
of the December 13 meeting, an auditor at DTTC wrote to Longtop inquiring why
XLHRS was a net creditor of Longtop.65
62
See id. ¶ 144.
63
Id. ¶ 145.
64
Id.
65
See id. ¶ 146.
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Plaintiffs next allege that on December 19, 2010, Palaschuk wrote an
e-mail to DTTC reiterating that in practice, Chinese companies routinely used
employees’ average, rather than actual, salaries in order to compute welfare
payments, and advising DTTC that Longtop had received a legal opinion stating
that its methodology for computing welfare payments was permissible under
Chinese law and, therefore, GAAP compliant.66 DTTC replied that the legal
opinion was ambiguous because it did not specifically address XLHRS, and, in
particular, whether Longtop could be jointly liable with XLHRS if XLHRS’s
welfare liability were increased.67 In light of this ambiguity, DTTC requested that
Palaschuk send “a separate analysis only on those employees contracted from
[XLHRS].”68
Plaintiffs allege that DTTC and Longtop subsequently discussed
Longtop’s welfare payments at a January 28, 2011 meeting with Longtop’s Audit
Committee.69 A draft agenda prepared for this meeting reveals that Longtop had
received a legal opinion stating that its arrangement with XLHRS was in accord
66
See id. ¶ 147.
67
See id. ¶¶ 148-149.
68
Id. ¶ 149 (quotation marks omitted) (emphasis removed).
69
See id. ¶ 151.
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with Chinese law, and that it had “no [potential for] joint liability to the
government or [XLHRS] for any underpa[yment] [of] social welfare . . . .”70
Plaintiffs further allege that redlines to the January 28, 2011 meeting agenda reveal
that DTTC was not satisfied with the legal opinion that Longtop had received:
instead, it raised questions about whether Longtop could be liable directly to the
employees of XLHRS for XLHRS’s underpayments of welfare.71
Plaintiffs allege that in a February 18, 2011 e-mail to DTTC,
Palaschuk once again stated that Chinese routinely used average salary to compute
their welfare payments, but acknowledged that, under U.S. GAAP, Longtop could
not rely on such practices if they were inconsistent with the law.72 In the same email, Palaschuk proposed obtaining a confirmation from the local Chinese social
welfare bureau stating that Longtop’s policies complied with Chinese law.73
Plaintiffs further allege that DTTC replied to Palaschuk that, under U.S. GAAP,
Longtop was obligated to record its legal obligation, not its actual payments.74 In
response, Palaschuk provided DTTC with a draft opinion from its law firm, Global
70
Id. (quotation marks omitted).
71
See id. ¶ 152.
72
See id. ¶ 153.
73
See id.
74
See id. ¶ 154.
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Law Office, and stated that, on the basis of this opinion, Longtop believed it had no
liability under U.S. GAAP for social welfare payments.75
Plaintiffs allege that on March 8, 2011, DTTC and Palaschuk
convened a conference call to discuss Longtop’s welfare obligations.76 After this
conference call, Palschuk sent an e-mail to Longtop executives stating that DTTC
had consented to Longtop’s use of a confirmation from the welfare bureau, and
noting that “[DTTC] said they may want to meet with the welfare bureau but I
think we can refuse this request.”77 In the same e-mail, Palaschuk stated that he
was “not 100% sure [DTTC] will accept our treatment but we will try our best.”78
Finally, Plaintiffs allege that DTTC ultimately accepted Longtop’s use of a
confirmation from the welfare bureau, and that on March 14, 2011, an auditor at
DTTC “edited the draft legal opinion that Longtop had obtained from [its law
firm].”79
Plaintiffs also allege that in July 2010, Longtop’s Chairman gifted
twenty thousand Longtop shares to defendant Lian’s brother, who then worked as a
75
See id.
76
See id. ¶ 157.
77
Id. (quotation marks omitted).
78
Id. (quotation marks omitted).
79
Id. ¶ 158.
-23-
clerk for the local tax bureau.80 Plaintiffs insinuate that this gift was a bribe
intended to secure for Longtop a confirmation that its welfare practices were in
accord with Chinese law,81 and, based on a May 12, 2011 memo to file by
Palaschuk, alleges that Longtop recorded this gift as CEO compensation, rather
than disclosing it to the public.82 Plaintiffs further allege that “DTTC was seeking
to avoid specifically disclosing that the gift was to Lian’s brother, and agreed [that]
this is a little murky.”83
III.
STANDARD OF REVIEW
A.
Rule 12(b)(6) Motion to Dismiss
A pleading must contain “a short and plain statement of the claim
showing that the pleader is entitled to relief.”84 “Such a statement must [] ‘give the
defendant fair notice of what the plaintiff’s claim is and the grounds upon which it
rests.’”85 In deciding a motion to dismiss pursuant to Rule 12(b)(6), the court
80
See id. ¶ 155.
81
See id.
82
See id. ¶ 155.
83
Id. (quotation marks omitted) (alteration in original).
84
Fed. R. Civ. P. 8(a)(2).
85
See Swierkiewicz v. Sorema N.A., 534 U.S. 506, 512 (2002) (quoting
Conley v. Gibson, 355 U.S. 41, 47 (1957), overruled in part on other grounds by
Bell Atl. Corp. v. Twombly, 550 U.S. 544, 561-563 (2007)).
-24-
“must accept all non-conclusory factual allegations as true and draw all reasonable
inferences in the plaintiff’s favor.”86
For the purposes of such motion, “. . . a district court may consider the
facts alleged in the complaint, documents attached to the complaint as exhibits, and
documents incorporated by reference in the complaint.”87 “Limited quotation does
not constitute incorporation by reference.”88 However, the court may consider a
document that is not incorporated by reference “where the complaint ‘relies
heavily upon its terms and effect,’ thereby rendering the document ‘integral’ to the
complaint.”89 Moreover, when a securities fraud complaint alleges that material
misstatements or omissions were made in public documents required to be filed
86
Simms v. City of New York, No. 11 Civ. 4568, 2012 WL 1701356, at
*1 (2d Cir. May 16, 2012) (citing Goldstein v. Pataki, 516 F.3d 50, 56 (2d Cir.
2008)).
87
DiFolco v. MSNBC Cable L.L.C., 622 F.3d 104, 111 (2d Cir. 2010)
(citing Chambers v. Time Warner, Inc., 282 F.3d 147, 153 (2d Cir. 2002)).
88
Cosmas v. Hassett, 886 F.2d 8, 13 (2d Cir. 1989) (quotation marks,
citations, and alteration omitted). Accord Sira v. Morton, 380 F.3d 57, 67 (2d Cir.
2004) (citation omitted).
89
Id. (quoting Mangiafico v. Blumenthal, 471 F.3d 391, 398 (2d Cir.
2006)). Accord Global Network Commc’ns, Inc. v. City of N.Y., 458 F.3d 150, 156
(2d Cir. 2006).
-25-
with the SEC, a court may take judicial notice of such documents, as well as
“related documents that bear on the adequacy of the disclosure . . . .”90
The court evaluates the sufficiency of the complaint under the “twopronged approach” suggested by the Supreme Court in Ashcroft v. Iqbal.91 Under
the first prong, a court “‘can . . . identify[] pleadings that, because they are no more
than conclusions, are not entitled to the assumption of truth.’”92 Thus,
“[t]hreadbare recitals of the elements of a cause of action, supported by mere
conclusory statements, do not suffice” to withstand a motion to dismiss.93
Under the second prong of Iqbal, “[w]hen there are well-pleaded
factual allegations, a court should assume their veracity and then determine
whether they plausibly give rise to an entitlement for relief.”94 A claim is plausible
“when the plaintiff pleads factual content that allows the court to draw the
90
Kramer, 937 F.2d at 774. Accord Staehr v. Hartford Fin. Servs.
Group, Inc., 547 F.3d 406, 425 (2d Cir. 2008).
91
556 U.S. 662, 678-79 (2009).
92
Hayden v. Paterson, 594 F.3d 150, 161 (2d Cir. 2010) (quoting Iqbal,
556 U.S. at 679). Accord Ruston v. Town Bd. for Town of Skaneateles, 610 F.3d
55, 59 (2d Cir. 2010).
93
Iqbal, 556 U.S. at 663 (citing Twombly, 550 U.S. at 555).
94
Id. at 679. Accord Kiobel v. Royal Dutch Petroleum Co., 621 F.3d
111, 124 (2d Cir. 2010).
-26-
reasonable inference that the defendant is liable for the misconduct alleged.”95
Plausibility “is not akin to a probability requirement;” rather, plausibility requires
“more than a sheer possibility that a defendant has acted unlawfully.”96
B.
Heightened Pleading Standard under Rule 9(b) and the PSLRA
Private securities fraud claims are subject to a heightened pleading
standard.97 First, Rule 9(b) requires that the circumstances constituting fraud be
alleged with particularity, although “[m]alice, intent, knowledge, and other
conditions of a person’s mind may be alleged generally.”
Second, the PSLRA further heightens the pleading standard in private
securities fraud cases by providing that:
In any private action arising under this chapter in which the
plaintiff may recover money damages only on proof that the
defendant acted with a particular state of mind, the complaint
shall, with respect to each act or omission alleged to violate this
chapter, state with particularity facts giving rise to a strong
inference that the defendant acted with the required state of
mind.98
95
Iqbal, 556 U.S. at 678 (quotation marks omitted).
96
Id. (quotation marks omitted).
97
See Meridian Horizon Fund, LP v. KPMG (Cayman), Nos.
11–3311–cv, 11–3725–cv, 2012 WL 2754933, at *2 (2d Cir. July 10, 2012).
98
15 U.S.C. § 74u-4(b)(2).
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A plaintiff has alleged facts giving rise to a “strong inference” of scienter “only if a
reasonable person would deem the inference of scienter cogent and at least as
compelling as any opposing inference one could draw from the facts alleged.”99 In
deciding whether the plaintiff has alleged facts showing a strong inference of
scienter, “a court must consider plausible, nonculpable explanations for the
defendant’s conduct, as well as inferences favoring the plaintiff.”100 The inquiry is
holistic, i.e. the allegations going to scienter are to be evaluated collectively.101
In addition to requiring that scienter be pleaded with specificity, the
PSLRA further provides that the complaint in a private securities fraud case 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 omission is made on information and
belief, . . . state with particularity all facts on which that belief is
formed.102
99
Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324
(2007).
100
Id. at 323-24.
101
See id. at 326.
102
15 U.S.C. § 78u-4(b)(1)(B). Cf. Saltz v. First Frontier, L.P., 485 Fed.
App’x 461, 463 (2d Cir. 2012) (“[W]hile we normally draw reasonable inferences
in the non-movant’s favor on a motion to dismiss, the PSLRA establishes a more
stringent rule for inferences involving scienter because the PSLRA requires
particular allegations giving rise to a strong inference of scienter.”) (quotation
marks and citations omitted).
-28-
IV.
APPLICABLE LAW
A.
Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5
Section 10(b) of the Securities Exchange Act of 1934 makes it illegal
to “use or employ, in connection with the purchase or sale of any security . . . any
manipulative or deceptive device or contrivance in contravention of such rules and
regulations as the Commission may prescribe . . . .”103 Under Rule 10b-5,
promulgated by the SEC under Section 10(b), one may not “make any untrue
statement of a material fact or [] omit to state a material fact necessary in order 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.”104 Although Section 10(b) does not expressly provide for a private right
of action, courts have long recognized an implied private right of action under
Section 10(b) and Rule 10b-5.105
103
15 U.S.C. § 78j(b).
104
17 C.F.R. § 240.10b-5.
105
See Kardon v. National Gypsum Co., 69 F. Supp. 512 (E.D. Pa. 1946)
(first case to recognize implied private right of action under Section 10(b));
Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 13 n.9 (1971)
(noting that “[i]t is now established that a private right of action is implied under
[Section] 10(b).”).
-29-
“To sustain a private claim for securities fraud under Section 10(b), ‘a
plaintiff must prove (1) a material misrepresentation or omission by the defendant;
(2) scienter; (3) a connection between the misrepresentation or omission and the
purchase or sale of a security; (4) reliance upon the misrepresentation or omission;
(5) economic loss; and (6) loss causation.’”106 There is no secondary liability
under Section 10(b),107 but “secondary actors like accountants may be held liable as
primary violators if all the requirements for primary liability are met . . . .”108
1.
Misstatements or Omissions of Material Fact
In order to satisfactorily allege misstatements or omissions of material
fact, a complaint must “state with particularity the specific facts in support of
[plaintiffs’] belief that [defendants’] statements were false when made.”109 “For
the purposes of Rule 10b-5, the maker of a statement is the person or entity with
106
Ashland Inc. v. Morgan Stanley & Co., Inc., 652 F.3d 333, 337 (2d
Cir. 2011) (quoting Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552
U.S. 148, 157 (2008)). Accord Erica P. John Fund, Inc. v. Halliburton Co., —
U.S. — , 131 S.Ct. 2179, 2184 (2011).
107
See Central Bank of Denver N.A. v. First Interstate Bank of Denver,
N.A., 511 U.S. 164, 191 (1994).
108
Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2d Cir. 1998)
(quoting Central Bank, 511 U.S. at 191).
109
Rombach v. Chang, 355 F.3d 164, 172 (2d Cir. 2004) (quotation
marks omitted).
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ultimate authority over the statement, including its content and whether and how to
communicate it.”110
“‘[A] fact is to be considered material if there is a substantial
likelihood that a reasonable person would consider it important in deciding
whether to buy or sell [securities] . . . .’”111 In situations “‘[w]here plaintiffs
contend defendants had access to contrary facts, they must specifically identify the
reports or statements containing this information.’”112 Mere “allegations that
defendants should have anticipated future events and made certain disclosures
earlier than they actually did do not suffice to make out a claim of securities
fraud.”113 “[A]n omission is actionable when the failure to disclose renders a
statement misleading.”114
2.
Scienter
110
Janus Capital Grp., Inc. v. First Derivative Traders, — U.S. —, 131
S.Ct. 2296, 2302 (2011).
111
Operating Local 649 Annuity Trust Fund v. Smith Barney Fund Mgmt.
LLC, 595 F.3d 86, 92–93 (2d Cir. 2010) (quoting Azrielli v. Cohen Law Offices, 21
F.3d 512, 518 (2d Cir. 1994)).
112
Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital
Inc., 531 F.3d 190, 197 (2d Cir. 2008) (quoting Novak v. Kasaks, 216 F.3d 300,
309 (2d Cir. 2000)).
113
Id. Accord Rothman v. Gregor, 220 F.3d 81, 90 (2d Cir. 2000).
114
In re Alstom SA, 406 F. Supp. 2d 433, 453 (S.D.N.Y. 2005) (citing In
re Time Warner Inc. Secs. Litig., 9 F.3d 259, 268 (2d Cir. 1993)).
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A plaintiff may plead scienter by “alleging facts (1) showing that the
defendants had both motive and opportunity to commit the fraud or (2) constituting
strong circumstantial evidence of conscious misbehavior or recklessness.”115
“‘Sufficient motive allegations entail concrete benefits that could be realized by
one or more of the false statements and wrongful nondisclosures alleged.’”116
“Motives that are generally possessed by most corporate directors and officers do
not suffice; instead, plaintiffs must assert a concrete and personal benefit to the
individual defendants resulting from the fraud.”117
“‘Where motive is not apparent, it is still possible to plead scienter by
identifying circumstances indicating conscious behavior by the defendant, though
the strength of the circumstantial allegations must be correspondingly greater.’”118
115
ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 99 (2d Cir.
2007) (citing Ganino v. Citizens Utils. Co., 228 F.3d 154, 168–69 (2d Cir. 2000)).
Accord Dandong v. Pinnacle Performance Ltd., No. 10 Civ. 8086, 2011 WL
5170293, at *11 (S.D.N.Y. Oct. 31, 2011) (quoting Lerner v. Fleet Bank, N.A., 459
F.3d 273, 290-91 (2d Cir. 2006)).
116
Campo v. Sears Holdings Corp., 371 Fed. App’x 212, 215 (2d Cir.
2010) (quoting Kalnit v. Eichler, 264 F.3d 131, 139 (2d Cir. 2001)).
117
Kalnit, 264 F.3d at 139. Accord ECA & Local 134 IBEW Joint
Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 198 (2d Cir.
2009).
118
Kalnit, 264 F.3d at 142 (quoting Beck v. Manufacturers Hanover
Trust Co., 820 F.2d 46, 50 (2d Cir. 1987)). Accord South Cherry St., LLC v.
Hennessee Grp. LLC, 573 F.3d 98, 109 (2d Cir. 2009); In re Novagold Res. Inc.
-32-
Under this theory, a plaintiff must show that the defendant’s conduct is “at the least
. . . highly unreasonable and [] represents an extreme departure from the standards
of ordinary care to the extent that the danger was either known to the defendant or
so obvious that the defendant must have been aware of it.”119 “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 they had a duty to
monitor.”120
An outside auditor will typically not have an apparent motive to
commit fraud, and its duty to monitor an audited company for fraud is less
demanding than the company’s duty not to commit fraud. Thus, “‘the failure of a
non-fiduciary accounting firm to identify problems with [a company’s] internal
controls and accounting practices does not constitute reckless[ness].’”121 “‘For
Secs. Litig., 629 F. Supp. 2d 272, 297 (S.D.N.Y. 2009) (quoting ECA, 553 F.3d at
198–99).
119
South Cherry St., 573 F.3d at 109 (quotation marks and emphasis
omitted). Accord ECA, 553 F.3d at 203.
120
In re Gildan Activewear, Inc. Secs. Litig., 636 F. Supp. 2d 261, 272
(S.D.N.Y. 2009) (quotation marks and citation omitted).
121
Stephenson v. PricewaterhouseCoopers, LLP, 482 Fed. App’x 618,
623 (2d Cir. 2012) (quoting Novak, 216 F.3d at 309) (alterations in original).
-33-
recklessness on the part of a non-fiduciary accountant to satisfy securities fraud
scienter, such recklessness must be conduct that is highly unreasonable,
representing an extreme departure from the standards of ordinary care.’”122 In a
common formulation, such recklessness must “‘approximate an actual intent to aid
in the fraud being perpetrated by the audited company.’”123
Recklessness has been adequately alleged if it appears from the
complaint that “‘[t]he accounting practices were so deficient that the audit
amounted to no audit at all, or an egregious refusal to see the obvious, or
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.’”124 “A complaint might reach [the] ‘no audit at
all’ threshold by alleging that the auditor disregarded specific ‘red flags’ that
‘would place a reasonable auditor on notice that the audited company was engaged
122
Meridian Horizon Fund, LP, 2012 WL 2754933, at *3 (quoting
Rothman, 220 F.3d at 98).
123
Id. (quoting Rothman, 220 F.3d at 98).
124
In re Scottish Re Group Secs. Litig., 524 F. Supp. 2d 370, 385
(S.D.N.Y. 2007) (quoting In re Refco, Inc. Secs. Litig., 503 F. Supp. 2d 611, 657
(S.D.N.Y. 2007)) (further citations omitted).
-34-
in wrongdoing to the detriment of its investors.’”125 “However, . . . merely
alleging that the auditor had access to the information by which it could have
discovered the fraud is not sufficient.”126
B.
Statute of Repose Applicable to Section 10(b)
A complaint alleging “fraud, deceit, manipulation, or contrivance”
under the Exchange Act “may be brought not later than the earlier of . . . 2 years
after the discovery of the facts constituting the violation; or . . . 5 years after such
violation.”127 “[C]ourts have consistently referred to the . . . longer [time] period as
a statute of repose.”128 Specifically, “[c]ourts in this district have treated Section
1658(b)(2) as a statute of repose and [] stated that the five-year period begins to
run from the time that the allegedly fraudulent representations were made.”129
The Second Circuit has stated that:
125
In re IMAX Secs. Litig., 587 F. Supp. 2d 471, 483 (S.D.N.Y. 2008)
(quoting In re Scottish Re Group Secs. Litig., 524 F. Supp. 2d at 385).
126
Id.
127
28 U.S.C. § 1658(b).
128
In re Exxon Mobil Corp. Secs. Litig., 500 F.3d 189, 199 (3d Cir. 2007)
(citations omitted).
129
Boudinot v. Shrader, No. 09 Civ. 10163, 2012 WL 489215, at *4
(S.D.N.Y. Feb. 15, 2012). Accord McCann v. Hy-Vee, Inc., 663 F.3d 926, 930 (7th
Cir. 2011) (concluding that Section 1658(b)(2) is a statute of repose, and, in dicta,
reasoning that Section 1658(b)(1) is also a statute of repose).
-35-
In general, a statute of repose acts to define temporally the right
to initiate suit against a defendant after a legislatively determined
time period. Unlike a statute of limitations, a statute of repose is
not a limitation of a plaintiff’s remedy, but rather defines the right
involved in terms of the time allowed to bring suit. . . . Therefore,
a statute of repose begins to run without interruption once the
necessary triggering event has occurred, even if equitable
considerations would warrant tolling or even if the plaintiff has
not yet, or could not yet have, discovered that she has a cause of
action.130
In sum, statutes of repose temporally limit plaintiffs’ right to bring suit, not the
remedies that are available to them, and are not subject to equitable tolling.131
C.
Leave to Amend
Whether to permit a plaintiff to amend its complaint is a matter
committed to a court’s “sound discretion.”132 Rule 15(a) provides that leave to
130
P. Stolz Family P’ship L.P. v. Daum, 355 F.3d 92, 102-103 (2d Cir.
2004). Accord City of Pontiac Gen. Employees’ Ret. Sys. v. MBIA, Inc., 637 F.3d
169, 175 (2d Cir. 2011) (“In contrast to a statute of repose, a statute of limitations
is intended to prevent plaintiffs from unfairly surprising defendants by resurrecting
stale claims.”).
131
See Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S.
350, 363 (1991) (prior to the enactment of Section 1658, holding that three year
statute of repose implied into private cause of action under Section 10(b) was not
subject to equitable tolling). See also Footbridge Ltd. Trust v. Countrywide Fin.
Corp., 770 F. Supp. 2d 618, 624 (S.D.N.Y. 2011) (holding that plaintiffs’ Section
11 and Section 12 claims were extinguished under the three-year statute of repose
found in 15 U.S.C. § 77m, and that equitable tolling did not apply to statute of
repose).
132
McCarthy v. Dun & Bradstreet Corp., 482 F.3d 184, 200 (2d Cir.
2007).
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amend a complaint “shall be freely given when justice so requires.” “When a
motion to dismiss is granted, the usual practice is to grant leave to amend the
complaint.”133 In particular, it is the usual practice to grant at least one chance to
plead fraud with greater specificity when a complaint is dismissed under Rule
9(b).134 Leave to amend should be denied, however, where the proposed
amendment would be futile.135
V.
DISCUSSION
The instant motion raises three issues. First, whether Plaintiffs’ claim
against DTTC is barred by the statute of repose to the extent that it is based on
DTTC’s October 24, 2007 audit opinion. Second, whether the Amended
Complaint adequately alleges scienter, and third, whether it adequately alleges a
material misstatement. Each issue is addressed below.
A.
Plaintiffs’ Claim Arising out of DTTC’s October 24, 2007 Audit
Opinion Is Barred by the Statute of Repose
DTTC argues that under the five-year statute of repose established by
Section 1658(b)(2), Plaintiffs’ claim against it must be dismissed to the extent that
133
Hayden v. County of Nassau, 180 F.3d 42, 53 (2d Cir. 1999).
134
See ATSI , 493 F.3d at 108.
135
See, e.g., Dougherty v. Town of N. Hempstead Bd. of Zoning Appeals,
282 F.3d 83, 87 (2d Cir. 2002).
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it is based on DTTC’s October 24, 2007 audit opinion, which did not appear in the
case until the Amended Complaint was filed on December 14, 2012.136 Plaintiffs
respond that these allegations should be deemed timely filed under Rule 15(c),137
and note that relation-back is freely granted in securities fraud cases when the
plaintiff “merely adds additional violations to pre-existing causes of action.”138
Because Plaintiffs ignore the distinction between statutes of repose
and statutes of limitations, their argument misses the mark. The rule that “[w]here
no new cause of action is alleged, relation back under Rule 15 is to be liberally
granted[]” derives from the principle that, in those circumstances, “‘adequate
notice of the matters raised in the amended pleadings has been given to the
opposing party within the statute of limitations by the general fact[] situation
136
See Defendant Deloitte Touche Tohmatsu CPA Ltd.’s Memorandum
in Support of Its Motion to Dismiss the Amended Consolidated Class Action
Complaint (“DTTC Mem.”) at 24.
137
See Plaintiffs’ Memorandum of Law in Opposition to DTTC’s Motion
to Dismiss the Amended Consolidated Class Action Complaint (“Opp. Mem”) at
25.
138
Id. (citing New Jersey Carpenters Vacation Fund v. Royal Bank of
Scotland Group, PLC, 720 F. Supp. 2d 254, 266 (S.D.N.Y. 2010) (granting relation
back to securities fraud claim over statute of limitations defense)).
-38-
alleged in the original pleading.’”139 This principle is inapplicable to statutes of
repose, under which it is irrelevant whether parties have notice of a claim.140
A statute of repose may be modified by another statute. This has been
referred to as “statutory tolling.”141 Some courts have held that the tolling rule of
American Pipe & Construction Co. v. Utah142 applies even to statutes of repose, on
the grounds that American Pipe is based on Rule 23 and is therefore a type of
statutory tolling.143 The trend in this District, though, is to hold a period of repose
inviolable unless specifically modified by statute.144
I am persuaded by the reasoning that, when a claim is barred by a
statute of repose, “Rule 15 may not be construed to permit relation back because
such a construction would conflict with the Rules Enabling Act, which provides . .
139
New Jersey Carpenters Vacation Fund, 720 F. Supp. 2d at 266
(quoting Stevelman v. Alias Research Inc., 174 F.3d 79, 86-87 (2d Cir. 1999)).
140
See P. Stolz Family P’ship L.P., 355 F.3d at 103 (“[A] repose period
can run to completion even before injury has occurred to a potential plaintiff,
extinguishing a cause of action before it even accrues.”).
141
Pace v. DiGuglielmo, 544 U.S. 408, 417 (2005) (referring to 28
U.S.C. § 2244(d)(2) as an example of “statutory tolling”).
142
414 U.S. 538 (1974).
143
See Footbridge Ltd. Trust, 770 F. Supp. 2d at 625 (collecting cases).
144
See id. at 626 (concluding that American Pipe is an equitable tolling
doctrine, and therefore does not apply to the three-year statute of repose applicable
to Section 13 claims).
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. that the rules prescribed by the Supreme Court (including Rule 15) ‘shall not
abridge, enlarge or modify any substantive right.’”145 Accordingly, Plaintiffs’
Section 10(b) claim against DTTC is barred to the extent that it arises out of
DTTC’s October 24, 2007 audit opinion.
B.
The Amended Complaint Does Not Adequately Allege Scienter
Plaintiffs argue that the Amended Complaint adequately alleges
scienter by pleading that DTTC: (1) allowed Longtop to persuade it to conduct
alternative revenue testing instead of third-party confirmations of revenue
contracts;146 (2) disregarded information by third parties that should have led it to
uncover Longtop’s fraud;147 (3) disregarded fraud risk factors at Longtop of which
it was aware, including the possibility for management to override Longtop’s
internal accounting controls;148 and (4) failed to heed the red flag allegedly
presented by Longtop’s interpretation of its social welfare obligations.149 Plaintiffs
145
In re IndyMac Mortgage-Backed Secs. Litig., 793 F. Supp. 2d 637,
643 (S.D.N.Y. 2011) (quoting 28 U.S.C. § 2072(b)). Accord Wal-Mart Stores, Inc.
v. Dukes, — U.S. —, 131 S.Ct. 2541, 2561 (2011) (holding that, under the Rules
Enabling Act, a class could not be certified contingent on defendant being unable
to litigate its statutory defenses).
146
See Opp. Mem. at 12-14.
147
See id. at 14-15.
148
See id. at 15-16.
149
See id. at 17-18.
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also re-argue several scienter theories that I rejected in the Dismissal Opinion.
These allegations are evaluated respectively below.
1.
DTTC Performing Alternative Revenue Testing Rather
than Third-Party Confirmation Was Not Reckless
Plaintiffs allege that, had DTTC insisted on obtaining third-party
confirmations of Longtop’s major revenue contracts in 2009, as it originally
proposed via e-mail, it would have uncovered Longtop’s fraud.150 Plaintiffs further
allege that performing third-party confirmations of the revenue contracts was a
required procedure under the circumstances,151 and that Longtop’s excuse that this
procedure would delay its 2009 Form 20-F should have increased DTTC’s
professional skepticism.152 Based on these allegations, Plaintiffs argue that DTTC
was reckless because it agreed to perform “‘alternative testing on revenue’” to
150
See Am. Compl. ¶ 123 (“Had DTT gone forward with obtaining
confirmations relating to Longtop’s three largest revenue contracts in 2009, it
would have learned, for example, that Longtop’s internal controls related to
revenue were grossly inadequate, out of step with industry practice, and presented
the opportunity for fraud.”).
151
See Opp. Mem. at 13 n.5 (citing AU § 330.34 (“There is a
presumption that the auditor will request the confirmation of accounts receivable
during an audit unless [certain circumstances exist] . . . An auditor who has not
requested confirmations in the examination of accounts receivable should
document how he or she overcame this presumption.”).
152
See id. at 12 (citing AU § 316 (stating that “domineering management
behavior” is an example of a “risk factor” that an auditor “should consider” if she
“becomes aware of it”)).
-41-
confirm Longtop’s major revenue contracts, rather than obtaining third party
confirmations.153 Plaintiffs analogize this case to Gould v. Winstar
Communications, Inc., which holds that an auditor who “‘consistently noticed,
protested, and then acquiesced in’ financial misrepresentations of an audit client
under pressure from client management” is reckless.154
These allegations do not withstand close scrutiny. As DTTC points
out, AU § 330.34, upon which Plaintiffs rely, relates to “confirmations of accounts
receivable[,]” not the confirmations of revenue contracts that form the basis for
these allegations.155 The Amended Complaint does not allege that DTTC failed to
confirm Longtop’s accounts receivable, and documents that the Amended
Complaint incorporates by reference indicate that DTTC did confirm Longtop’s
accounts receivable.156
153
Id. at 13 (quoting Am. Compl. ¶ 119).
154
Id. at 12 (quoting Gould v. Winstar Commc’ns, Inc., 692 F.3d 148,
158-59 (2d Cir. 2012)).
155
See DTTC’s Memorandum in Support of Its Motion to Dismiss the
Amended Consolidated Class Action Complaint (“Supp. Mem.”) at 14.
156
See 5/29/07 Audit Committee Meeting Minutes, Ex. D to Howe Decl.,
at 88628 (referencing “confirmation[s]” of “accounts receivable”).
-42-
Direct confirmation of revenue contracts is not a presumptively
required audit step under the GAAS.157 The e-mail chain upon which these
allegations rest reveals that DTTC initially took the position that third-party
confirmation of revenue contracts was required, based on its reading of
international auditing standards and a concept release proposed by the PCAOB for
notice and comment, but was persuaded by Palaschuk that, under U.S. GAAS, this
procedure was not required.158
Palaschuk pointed out that conducting third-party confirmations of
revenue contracts was not presumptively required under the GAAS, and also gave
numerous reasons why it was not necessary under the circumstances. He noted
that Longtop: (1) had no individually material contracts for the 2009 fiscal year,
and no long-term material contracts; (2) had never modified a contract; (3) had bad
debt of less than 0.5% of its sales; and, (4) had many contracts with, and was
therefore under the scrutiny of, large companies, making fraud more difficult.159
157
See AU § 316.54 (stating that “[c]onfirming with customers certain
relevant contract terms and the absence of side agreements” is something that an
auditor “may want to consider[,]” if there is “an identified fraud risk that involves
improper revenue recognition”).
158
See 4/2009 E-mail Chain, Ex. I to Howe Decl.
159
See id. (4/22/09 Palaschuk e-mail to DTTC at 6:10 p.m.).
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DTTC was ultimately persuaded by Palaschuk’s argument,160 but
noted that it would need to re-visit the issue if new auditing standards were to be
released.161 Furthermore, the same e-mail chain reveals that DTTC confirmed the
terms of Longtop’s revenue contracts in the course of its audit of Longtop’s fiscal
year ending March 31, 2008,162 refuting Plaintiffs’ allegation that DTTC “fail[ed]
to undertake any meaningful investigation to confirm Longtop’s revenue contracts
throughout the Class Period . . . .”163 Based on these facts, this case is
distinguishable from Gould, where the auditor defendant knew that the audited
company had committed serious accounting violations, but nevertheless issued
clean audit opinions.164
Plaintiffs’ argument that Palaschuk’s resistance when DTTC proposed
conducting client confirmations of revenue contracts was a “significant red flag” is
160
Id. (4/22/09 DTTC e-mail to Palaschuk at 6:20 p.m.) (“Based on the
fact that there is no significant individual contract for the year ended March 31,
2009 and the reasons [Palaschuk] mentioned in [his] email, we would perform
alternative testing on revenue instead of confirmation.”).
161
See id.
162
See id. at 1114207.
163
Am. Compl. ¶ 122.
164
See Gould, 692 F.3d at 158-59.
-44-
tainted by hindsight.165 Once fraud has been revealed, it is always obvious which
audit procedures would have revealed the fraud earlier, and resistance to those
audit procedures always appears suspicious. To suggest that every available audit
procedure must be conducted, though, is unrealistic. Time and money are limited,
and information comes at a price. Subject to these constraints, auditors and their
clients must necessarily decide whether it is cost-effective to perform audit
procedures that are not required. Given this understanding, a “plausible,
nonculpable explanation[] for [] [DTTC’s] conduct” is that it was persuaded by
Palaschuk to cut costs by not performing an audit procedure that was not required
by the relevant standards.166 This leads to an inference of, at worst, laziness, but
not recklessness.
Finally, Plaintiffs argue that whether DTTC “‘appropriately’
determined that confirmations were not required by PCAOB[] . . . is a matter for
expert testimony [that] cannot be decided on a motion to dismiss.”167 This
argument is not persuasive. As an initial matter, the case cited by Plaintiffs
contradicts its argument that any dispute about auditing or accounting standards,
165
Opp. Mem. at 13-14.
166
Tellabs, 551 U.S. at 323-24.
167
Opp. Mem. at 13 (citing In re Global Crossing, Ltd. Secs. Litig., 322
F. Supp. 2d 319, 339 (S.D.N.Y. 2004)).
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however slight, is sufficient to defeat a motion to dismiss.168 This is particularly so
when the dispute arises out of the GAAS, rather than the GAAP, because the
GAAS stem from a single source, the PCAOB.169 Moreover, there is no dispute
here that “cannot be determined in advance of the development of the record.”170
DTTC has pointed to authority that the PCAOB, at the relevant time, did not
require confirmation of revenue contracts, and Plaintiffs have not pointed to
contrary authority. Even in a case not governed by the PSLRA, ipse dixit
assertions cannot defeat a motion to dismiss.171
In sum, DTTC initially suggested that it perform an audit procedure
that was not required by the PCAOB; it was persuaded to forego this procedure by
a reasoned argument; and it nevertheless insisted that it would revisit the issue
should auditing standards change. In light of these facts, Plaintiffs’ allegations
168
See Global Crossing, 322 F. Supp. 2d at 346 (“Violations of GAAP,
standing alone, are insufficient to state a securities fraud claim.”).
169
See id. at 339 (“‘The determination that a particular accounting
principle [under GAAP] is generally accepted may be difficult because no single
source exists for all principles.’”) (quoting Shalala v. Guernsey Mem’l Hosp., 514
U.S. 87, 101 (1995)).
170
Id.
171
See, e.g., Simms, 2012 WL 1701356, at *1 (a district court hearing a
motion to dismiss need not credit conclusory allegations).
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regarding revenue confirmations do not support the inference that DTTC acted
with scienter.
2.
The Third-Party Information Alleged in the Amended
Complaint Does Not Support an Inference of Scienter
Plaintiffs argue that DTTC was reckless because it ignored the Wedge
Reports, the information it received from YTEC’s CFO, and the market rumors
discussed at the November 2, 2010 meeting between Longtop and DTTC.172 I will
first consider the Wedge Reports, which issued prior to DTTC’s final Class Period
audit opinion, and then consider the remaining two sources of third-party
information.
a.
The Wedge Reports
Plaintiffs acknowledge that the Wedge Reports were “generally
positive” about Longtop, but argue that they nevertheless “should have caused
DTT[C] to increase the level of scrutiny it applied to its audits . . . .”173 However,
172
See Opp. Mem. at 14-15.
173
Id. at 14 (citing In re Health Mgmt., Inc. Secs. Litig., 970 F. Supp.
192, 203 (E.D.N.Y. 1997) (holding that “failure to follow up on an analyst letter
which alerted [outside auditor] of artificially inflated accounts receivable levels, by
contacting the named sources of information about the accounts receivable fraud”
constituted evidence of recklessness). See 3/23/10 Wedge Partner Reports, Ex. J to
Howe Decl, at 39818 (“We continue to take a deeper look at Longtop, and today
we met with management. Without undermining our generally positive view of this
company[’]s business prospects, our concerns on margins and the acquisition
remain.”).
-47-
Plaintiffs do not identify the steps that a non-reckless auditor would have taken
under the circumstances. This lapse is probably explained by the Wedge Reports’
lack of specificity. The analyst reports held to support an inference of scienter in
In re Health Management, Inc. Securities Litigation, which Plaintiffs cite, named a
specific type of fraud and supported this information with named sources.174
Following up with those sources would be a natural audit procedure. By contrast,
the Wedge Reports speculated that “Longtop may have been delaying payments [to
XLHRS][,]” and stated that “there does not seem to be a good business reason to
set up a separate, private company to handle this type of benefits management[,]”
but deferred drawing conclusions until the conference call scheduled by Longtop
for March 31, 2010.175 In short, generalized speculations hedged within generally
positive reports are not red flags indicative of auditor scienter.
The facts surrounding the Wedge Reports further support the
inference that DTTC was not reckless. The final Wedge Report issued on March
23, 2010.176 The next day, Longtop obtained a legal opinion re-confirming the
174
See In re Health Mgmt., Inc. Secs. Litig., 970 F. Supp. at 203.
175
3/23/10 Wedge Partner Reports, at 39818-39819.
176
See Am. Compl. ¶ 127.
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legality of its use of XLHRS, which it then shared with DTTC.177 Subsequently,
on March 31, 2010, “Longtop convened a conference call for analysts and
investors to address ‘various questions’ that Longtop received regarding its
relationship with XLHRS . . . .”178 During this call, Longtop explained that: (1)
XLHRS used the “Longtop” name to provide employees with a closer affiliation to
Longtop; (2) Longtop’s relationship with XLHRS did not violate Chinese law; and
(3) Longtop was complying with its social welfare obligations.179 Wedge Partners
attended this meeting, and there are no allegations that their concerns were not
allayed by Longtop’s explanations.180
In sum, the concerns raised by the Wedge Reports were disclosed to
the public and artfully addressed by Longtop, whose explanations fooled the SEC,
the investing public, and Wedge Partners. The most compelling inference
stemming from the Wedge Reports is that Longtop concealed its fraud from
177
See 3/24/10 Legal Opinion (cited in Am. Compl. ¶¶ 147-148), Ex. K
to Howe Decl., at 67963-65; 12/19/10 E-mail from Palaschuk to T. Wang (of
DTTC) (cited in Am. Compl. ¶ 147), Ex. L to Howe Decl., at 67960.
178
Am. Compl. ¶ 73.
179
See id.
180
See 3/23/10 Wedge Partner Reports at 39818 (“On March 31, Longtop
will host a meeting for investors in person and by phone with the general manager
of Longtop Human Resources, which we will attend in person.”).
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DTTC, not that DTTC was on notice of Longtop’s fraud but, for some unknown
reason, chose to allow it to persist.181
b.
The Meeting with YTEC’s CFO and the November 2,
2010 Meeting
In order to evaluate the remaining allegations regarding third-party
information, it is helpful to summarize the time-line involved. DTTC’s final Class
Period audit opinion was publicized on July 16, 2010. The meeting with YTEC’s
CFO occurred on October 2, 2010, and the meeting between DTTC and Longtop
occurred on November 2, 2010. Subsequently, DTTC issued its Resignation Letter
on May 23, 2011.
Based on this time-line, to the extent that a claim arises out of the
meeting with YTEC’s CFO and/or the November 2, 2010 meeting, this claim must
rest on a duty on the part of DTTC to correct its July 16, 2010 audit opinion at
some point between the October 2, 2010 meeting with YTEC’s CFO and the May
23, 2011 Resignation Letter. For the reasons that follow, DTTC was not reckless
in failing to issue a correction.
181
Cf. Meridian Horizon Fund, LP, 487 Fed. App’x at 641.
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Plaintiffs argue that DTTC’s duty to correct arose under the GAAS,
which required it to “take action to prevent future reliance on its audit report.”182
However, while the GAAS is suggestive of an auditor’s duty of care, it is not a
source of liability under the Exchange Act.183 I therefore turn to Second Circuit
precedent, which holds that:
an [auditor] . . . becomes primarily liable under § 10(b) and Rule
10b-5 when it (1) makes a statement in its certified opinion that is
false or misleading when made; (2) subsequently learns or was
reckless in not learning that the earlier statement was false or
misleading; (3) knows or should know that potential investors are
relying on the opinion and financial statements; yet (4) fails to
take reasonable steps to correct or withdraw its opinion and/or the
financial statements; and (5) all the other requirements for liability
are satisfied.184
182
Am. Compl. ¶ 132 (citing AU § 561 (stating that, although an auditor
has no free-standing duty to investigate, update, or correct an opinion once its
report has been released, it has a duty to investigate reliable facts of which it
becomes aware after its report is released and that existed prior to its report, and
take actions appropriate under the circumstances)).
183
See, e.g., ECA, Local 134 IBEW Joint Pension Trust of Chicago, 553
F.3d at 200 (“‘[A]llegations of . . . accounting irregularities, standing alone, are
insufficient to state a securities fraud claim . . . . Only where such allegations are
coupled with evidence of corresponding fraudulent intent might they be
sufficient.’”) (quoting Novak, 216 F.3d at 309).
184
Overton v. Todman & Co., CPAs, P.C., 478 F.3d 479, 486-87 (2d Cir.
2007).
-51-
The Amended Complaint does not allege that DTTC actually learned of Longtop’s
fraud prior to issuing the Resignation Letter.185 Therefore, DTTC acted with
scienter only if it was “reckless in not learning that [its July 16, 2010 audit opinon]
was false or misleading” based on the meeting with YTEC’s CFO and/or the
November 2, 2010 meeting.186
To the extent that Plaintiffs’ allegations are based on DTTC’s duty to
correct, DTTC benefits from a doubly deferential standard. Under the PSLRA, and
given the facts of the case, it is the Plaintiffs’ general burden to allege facts
showing that the strongest inference is that DTTC conducted an audit akin to “no
audit at all.”187 And to the extent that Plaintiffs’ allegations are based on DTTC’s
failure to correct its audit opinions, they have the additional burden of pleading
facts showing that DTTC was reckless for not learning that its earlier audit opinion
was false of misleading. Moreover, the PCAOB standards proffered by Plaintiffs
are triggered by the auditor “subsequently discover[ing] information [that was]
185
Cf. Am. Compl. ¶ 271 (“Had DTT conducted its audits in accordance
with GAAS, it would have reacted to the numerous, obvious ‘red flags’ set forth
above and, in so doing, would have discovered the truth about Longtop’s
operations.” (emphasis added).
186
Overton, 478 F.3d at 487.
187
In re Scottish Re Group Secs. Litig., 524 F. Supp. 2d at 385 (quotation
marks and citations omitted).
-52-
found [] to be reliable[;]” and even after discovering such information, require only
that “[t]he auditor [] take whatever steps [it] deems necessary to satisfy himself
that the client has made the disclosures [appropriate under the circumstances][.]”188
Plaintiffs have failed to plead facts creating a strong inference that
DTTC was reckless under this test. The alleged sources of information — the sayso of Longtop’s competitor’s CFO (a person with a motive to malign Longtop), the
hearsay statement of a reputed CCB employee, and vague “market rumors” —
were less than reliable, and DTTC’s duty to investigate was correspondingly
slight.189 Notwithstanding this fact, DTTC evidently took the third-party
information seriously.
After its meeting with YTEC’s CFO, DTTC informed Palaschuk that
it had to perform “additional [audit] procedures[]” based on the CFO’s hearsay
statements.190 And the November 2 meeting minutes referenced in the Amended
Complaint further support the point that DTTC did not recklessly ignore the third188
AU § 561.
189
See id. (stating that the auditor’s duty upon receiving information after
issuing an opinion varies with the reliability of that information).
190
Am. Compl. ¶ 128 (quotation marks omitted) (alteration in original).
Accord 11/8/10 Email from [DTTC] to Palaschuk (cited in Am. Compl. ¶ 128), Ex.
N to Howe Decl, at 4000858 (stating that “normally Deloitte [would] not pay
attention to hearsay, but because this was discussed with partners in Beijing it is
very high profile. Internally they must do some additional procedures”).
-53-
party information. At this meeting, Longtop convincingly answered the market
rumors relating to its above-market margins and XLHRS.191 Furthermore, DTTC
suggested that Longtop hire an independent investigator to look into the hearsay
allegation that its revenue from CCB contracts had been misstated, despite the fact
that DTTC had “seen no indications of fraud or that Longtop’s revenue from CCB
is inaccurate. . . .”192 In response, Longtop stated that it would “would confirm
with . . . legal counsel whether [it] thought an investigation was necessary.”193
Plaintiffs argue that DTTC was reckless because it “did not undertake
an investigation of its own.”194 But there is no indication that a diligent auditor
would have done more under the circumstances. The applicable auditing standards
require an auditor to correct its opinions only upon discovering reliable
information and instructs the auditor, in determining whether information is
reliable, to “discuss the matter with [its] client . . . and request cooperation in
whatever investigation may be necessary.”195 Here, despite the fact that the sources
of information were unreliable, and contradicted by information that DTTC had
191
See 11/2/10 Meeting Minutes (summarized above).
192
Id. at 107690.
193
Id.
194
Opp. Mem. at 15 (citing Am. Compl. ¶¶ 130-131).
195
AU § 561.
-54-
seen first-hand, DTTC raised the issue with Longtop management and suggested
an investigation. Given that there was no indication that something was amiss with
Longtop’s CCB contracts, DTTC’s failure to conduct an independent investigation
does not bespeak recklessness.
These facts are a far cry from Overton v. Todman & Co., CPAs, P.C.,
in which the defendant auditor failed to investigate the fact that the audited
company’s payroll taxes, its largest single line-item expenditure in one year, had
dropped to zero in the following two years, despite being aware that “plainly
people were working and payroll taxes were due . . . .”196 Here, the alleged
third-party sources of information were unreliable, but DTTC nevertheless
suggested additional audit procedures based on them. Compared to recklessness, it
is a more compelling inference that DTTC attempted to discharge its auditing
duties upon receiving the alleged third-party information, but was duped by
Longtop as to is import. Accordingly, DTTC was not “reckless in not learning”
that its audit opinions were false or misleading based on the alleged third-party
information.197
3.
DTTC Did Not Recklessly Disregard Internal Control
Deficiencies and Risk Factors at Longtop
196
Overton, 478 F.3d at 481 (quotation marks omitted).
197
Id. at 487.
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Plaintiffs argue that DTTC was reckless because, from 2007 to 2010,
it noted actual or potential problems with Longtop’s internal controls, as well as
risk factors at Longtop, but nevertheless issued audit opinions certifying Longtop’s
financial statements.198 The crux of Plaintiffs’ argument is that the instances where
DTTC pointed out problems at Longtop bespeak recklessness, because DTTC
“disregard[ed]” these problems.199 In support of this argument, Plaintiffs cite
precedents holding that a compelling inference of auditor recklessness exists when
the auditor is either aware of and disregards information indicative of fraud,200 or
has a relationship with the audited company such that it may be inferred that it
reviewed materials indicative of fraud.201 For the four following reasons,
Plaintiffs’ argument is not persuasive.
198
See Opp. Mem. at 15-16 (citing Am. Compl. ¶¶ 95-104; 111-114).
199
Id. at 15.
200
See id. (citing Varghese v. China Shenghuo Pharm. Holdings, Inc.,
672 F. Supp. 2d 596, 610 (S.D.N.Y. 2009) (holding that allegations that auditor
was aware of information indicating fraud supported a strong inference of
recklessness)).
201
See id. (citing In re IMAX Secs. Litig., 587 F. Supp. 2d at 484 (finding
that, unlike typical outside auditor, defendant auditor was extensively involved in
creating and maintaining accounting policy that gave rise to the alleged fraud,
leading to the inference that audited company reviewed documents containing red
flags, and, on the basis of this finding, holding that auditor was reckless for
purposes of motion to dismiss)).
-56-
First, DTTC’s audit of Longtop’s December 31, 2006 financial
statements suggests that it was not reckless during its later auditing engagements.
During this audit, DTTC was not required to audit Longtop’s internal controls.202
Despite this fact, it identified one “material weakness” and one “significant
deficien[cy]” in Longtop’s internal controls during the course of this audit.203 It
then communicated these problems to Longtop management,204 which disclosed
them to the public in its 2007 Form F-1.205 As DTTC points out, it is unlikely that
an auditor would investigate, discover, and disclose internal control deficiencies
when it had no obligation to do so, only to turn a blind eye to them after being
engaged to ferret them out.206
Second, Plaintiffs do not allege facts showing that DTTC was on
notice of Longtop’s fraud. Instead, they equivocate between the accounting
concept of a fraud risk factor and the legal concept of notice of actual fraud. The
202
See Am. Compl. ¶ 163 (quoting 10/24/07 Longtop SEC Rule
424(b)(4) Prospectus).
203
Id. ¶¶ 99-100.
204
See id.
205
10/2/07 Longtop Form F-1 at 21. Longtop’s public SEC filings reveal
that it subsequently took steps to correct the problems identified by DTTC. See
10/24/07 Longtop Form 424(b)(4), Ex. B to Soni Decl., at 22.
206
See Supp. Mem. at 6.
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GAAS states that “[f]raud risk factors do not necessarily indicate the existence of
fraud[,]”207 and the risk factors that DTTC identified at Longtop are similar to
those commonly disclosed by reputable companies.208 DTTC’s awareness of the
generic risk factors alleged in the Amended Complaint does not indicate that it was
on notice of actual fraud at Longtop.
Third, Plaintiffs do not allege facts showing that DTTC turned a blind
eye to the problems it identified at Longtop. Instead the facts show that, year after
year, DTTC identified problems with Longtop’s financial reporting, and then made
plans to address those problems.209 This describes a diligent audit, not “no audit at
all . . . .”210
Plaintiffs argue that, for the purposes of this motion, this Court must
infer that DTTC never “actually performed any of the enhanced audit procedures”
207
AU § 316.31.
208
See Supp. Mem. at 13 (citing 6/26/12 Form 10-K of Oracle
Corporation, Ex. G to Soni Decl., at 79 (identifying risk of “management override
of the controls”); 3/15/12 Form 10-K of Build-A-Bear Workshop, Inc. at 40
(same)).
209
See Am. Compl. ¶¶ 96-104. See also, e.g., 5/26/09 Sarbanes-Oxley
404 Attestation Status Update (cited in Am. Compl. ¶ 103), Ex. G to Howe Decl.,
at 63294 (listing numerous specific, planned responses to various categories of
auditing risks).
210
In re Scottish Re Group Secs. Litig., 524 F. Supp. 2d at 385 (quotation
marks and citations omitted).
-58-
that it planned, because it “raised the very same deficiencies and fraud risk factors
year after year . . . .”211 This argument ignores that, under the PSLRA, “‘a court
must consider plausible, nonculpable explanations for the defendant’s conduct, as
well as inferences favoring the plaintiff.’”212 Beyond the bare fact that Longtop
was eventually found to be engaged in fraud, and despite having access to copious
discovery, Plaintiffs have not alleged any facts showing that DTTC failed to
perform the audit procedures that it planned. Nor have they alleged facts showing
that the failure to perform these audit procedures — if there was any such failure
— amounted to recklessness. For these reasons, DTTC’s identification of risk
factors at Longtop does not create a strong inference of recklessness.213
Finally, DTTC disclosed to the public that there was a risk of
management override at Longtop during the only two years in which it rendered an
opinion on Longtop’s internal controls.214 This disclosure negates Plaintiffs’
211
Opp. Mem. at 16.
212
Meridian Horizon Fund, LP, 2012 WL 2754933, at *2 (quoting
Tellabs, 551 U.S. at 323-24).
213
I further note that drawing an adverse inference from DTTC’s
attempts to strengthen Longtop’s financial controls would be inconsistent with the
policy animating Federal Rule of Evidence 407, which prohibits using subsequent
remedial measures as evidence of liability.
214
See 6/29/09 Longtop Form 20-F at 99 (“Because of the inherent
limitations of internal control over financial reporting, including the possibility of
-59-
allegation that DTTC did “nothing . . . to alert the investing public” of the internal
control risk at Longtop.215 Moreover, the Amended Complaint does not allege
facts sufficient to show that DTTC was required to make greater disclosures than it
did during the Class Period.
In the final analysis, the present allegations could have been drawn
from the auditing engagements of any of a thousand reputable companies.
Plaintiffs argue, at core, that identifying risk factors at a company ultimately
discovered to be engaged in fraud should expose auditors to legal liability. But this
is not the law. The “animating purpose of the Exchange Act[] [is] to insure honest
securities markets and thereby promote investor confidence.” 216 Plaintiffs’
argument would vitiate this purpose, by exposing an auditor to liability when that
auditor identifies risk factors at a company later found to be engaged in fraud, but
fails to catch its fraud. For this reason, and for the reasons stated above, DTTC’s
identification of risk factors and internal control deficiencies at Longtop does not
collusion or improper management override of controls, material misstatements
due to error or fraud may not be prevented or detected on a timely basis.”); 7/16/10
Longtop Form 20-F at 97 (same).
215
Am. Compl. ¶ 102.
216
United States v. O’Hagan, 521 U.S. 642, 658 (1997) (citation
omitted).
-60-
create an inference of scienter that is stronger and more compelling than the
strongest competing inference.
4.
Longtop’s Interpretation of Its Welfare Obligations Was
Not a Red Flag that DTTC Recklessly Disregarded
The Dismissal Opinion rejected the argument that Longtop’s
relationship with XLHRS presented a red flag.217 Plaintiffs now advance a variant
of that argument, namely that DTTC was reckless because it “failed to investigate
the true relationship between [Longtop and] XLHRS and the impact of that
relationship and Longtop’s welfare underpayments on the company’s financial
statements . . . .”218 This argument is not persuasive.
As an initial matter, I note that Longtop accrued a liability equal to its
maximum expected welfare payment.219 This implies that DTTC was not reckless
for failing to investigate Longtop’s welfare payments: based on the facts alleged,
such an investigation merely would have revealed that Longtop had, based on a
seemingly-reasonable interpretation of the law, paid a certain amount of social
217
See In re Longtop, 2012 WL 5512176, at *8 (holding that the fact that
XLHRS’s relationship with Longtop was disclosed to the investing public for years
prior to Longtop’s fraud unraveling negated inference that this relationship
presented a red flag) (citations omitted).
218
Opp. Mem. at 17.
219
See Am. Compl. ¶ 140.
-61-
welfare, while accruing against the possibility that its interpretation would not hold
up.
Furthermore, the allegations summarized above reveal that,
throughout its auditing engagement with Longtop, DTTC asked probing questions
about Longtop’s accounting treatment of XLHRS, and demanded answers.220 This
pattern is exemplified by the fact that, after its final Class Period audit opinion had
been released, DTTC required a confirmation from the Chinese government
regarding Longtop’s welfare payments, insisted that it be able to discuss the legal
opinion with Longtop’s outside law firm, and pressed for further analysis beyond
this opinion.221 In response to this scrutiny, Longtop desperately attempted to
throw DTTC off the scent.222 These facts reinforce the conclusion of the Dismissal
Opinion that “the strongest inference is that DTTC was duped by Longtop, not that
it recklessly enabled them.”223
220
See id. ¶¶ 133-157.
221
See id. ¶ 157.
222
See id. (“‘[DTTC] said they may want to meet with the welfare bureau
but I think we can refuse this request . . . . [N]ot 100% sure [DTTC] will accept our
treatment but we will try our best.’”) (quoting Palaschuk e-mail to Longtop
management).
223
In re Longtop, 2012 WL 5512176, at *9.
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Ultimately, Plaintiffs’ argument that Longtop’s interpretation of its
welfare obligations shows that DTTC was reckless depends on the proposition that
a company’s attempts to reduce its costs by seeking a favorable interpretation of
the law should put an auditor on notice of fraud. In reality, of course, reputable
companies routinely attempt to reduce their governmental liabilities to the extent
legally permissible. Longtop’s attempts to do so here were not a red flag of fraud,
and DTTC’s probing questions about these attempts support the inference that it
was not reckless.
Relatedly, Plaintiffs argue that “Lian’s July 2010 gift of 20,000
Longtop shares to his brother” supports an inference of scienter, because this gift
was made “just prior to Longtop’s receipt of the social welfare confirmation.”224
Because the facts alleged do not support Plaintiffs’ insinuation that this gift had
anything to do with Longtop’s welfare obligations, I reject this argument. In fact,
for the following four reasons, the gift does not suggest any impropriety on
DTTC’s part at all.
First, Lian’s brother was at the tax bureau, not the welfare bureau,
and the Amended Complaint does not allege he had any involvement with the
224
Opp. Mem. at 18 n.7.
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confirmation sought by Longtop.225 Second, the Amended Complaint does not
allege that DTTC was aware of the Chairman’s gift when it issued its 2010 audit
opinion; nor does it allege facts showing that DTTC was reckless in not correcting
that opinion when it learned of the gift. Third, Palaschuk’s May 12, 2011 memo
expressly states that the Chairman’s brother “does not work on or have any
involvement in the review of any of Longtop’s tax filings[,]”226 negating any
potential impropriety relating to Longtop’s tax liability. Finally, DTTC’s comment
that “this is a little murky” pertained not to the propriety or purpose of the gift, but
rather the technical question of how a gift of shares to the Chairman’s relative
should be accounted for.227
5.
Plaintiffs’ Remaining Allegations Do Not Create a Strong
Inference of Scienter
Plaintiffs reassert their previously rejected argument that the
magnitude of Longtop’s fraud, and the alleged rapidity and ease with which it was
discovered, indicate that DTTC acted with scienter.228 However, the basis for
225
226
Cf. id.
5/12/11 Memo from D. Palaschuk to File, Ex. O to Howe Decl., at
0140781.
227
5/13/11 E-mail from Palaschuk to T. Bancroft, Ex. M to Soni Decl., at
0149405.
228
See Opp. Mem. at 18-19.
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rejecting these arguments remains the same as it did in the Dismissal Opinion.
Like the CAC, the Amended Complaint reveals that DTTC was a target of
Longtop’s fraud, and that DTTC ultimately uncovered Longtop’s fraud, and noisily
resigned.229 And like the CAC, the Amended Complaint does not allege facts
showing that, prior to its resignation, DTTC “‘fail[ed] to conduct a thorough and
objective audit . . . .’”230 Therefore, the Dismissal Opinion’s conclusion that the
fraud’s magnitude and mode of discovery do not create a strong inference of
scienter remains intact.231
The remaining allegations of the Amended Complaint mostly amount
to a stew of accounting and auditing standards.232 The violation of such standards
establishes, at most, negligence.233 Moreover, the facts alleged do not suggest that
229
See Am. Compl. ¶ 57.
230
Opp. Mem. at 19 (quoting Global Crossing, 322 F. Supp. 2d at 347).
231
See In re Longtop, 2012 WL 5512176, at *9.
232
See, e.g., Am. Compl. ¶¶ 83-85 (alleging that an auditor must exercise
“due professional care and professional skepticism”) (citing AU § 230).
233
See Novak, 216 F.3d at 309 (“[A]llegations of GAAP violations or
accounting irregularities, standing alone, are insufficient to state a securities fraud
claim . . . . Only where such allegations are coupled with evidence of
corresponding fraudulent intent might they be sufficient.”) (quotation marks and
citations omitted). See also ECA, Local 134 IBEW Joint Pension Trust of Chicago,
553 F.3d at 201 (holding that failure to classify entity as related-party did not give
rise to an inference of recklessness).
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DTTC violated applicable auditing standards. Instead, as explained above,
Plaintiffs’ arguments generally rest on the proposition that there must have been
auditing violations, because DTTC failed to detect Longtop’s fraud earlier. For the
reasons stated in the Dismissal Opinion, such allegations are insufficient to state a
claim against an independent auditor under the PSLRA. I have considered the
remaining scienter allegations of the Amended Complaint and find them to be
meritless.
6.
Plaintiffs’ Allegations Fail to Create a Strong Inference of
Scienter
Although the Amended Complaint adds copious factual allegations
against DTTC, the deficiencies animating the Dismissal Opinion’s holding persist.
Like the CAC, the Amended Complaint “does little more than allege that, had
DTTC performed a better audit, Longtop’s fraud would have been uncovered
sooner[;]” accordingly, the most compelling inference is still that “DTTC was
duped by Longtop, not that it recklessly enabled [it].”234
In fact, this inference is strengthened by the Amended Complaint.
The Amended Complaint reveals that DTTC identified risk factors at Longtop,
even when it had no obligation to do so; disclosed to the public problems at
Longtop of which it was aware, and planned appropriate responses; asked probing
234
In re Longtop, 2012 WL 5512176, at *9.
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questions about Longtop’s welfare policies, even though its audit opinion had
already been released; and took third-party allegations seriously, despite their
dubious reliability. In light of these facts, it is reasonable to infer that the reports
that ultimately led DTTC to uncover Longtop’s fraud came about as a result of
DTTC’s efforts during the Class Period. That Longtop stayed one step ahead of
DTTC during the Class Period does not justify the assertion of liability over
DTTC. In short, because the facts alleged fall far short of showing that DTTC
conducted “no audit at all,”235 Plaintiffs have not adequately alleged that DTTC
was reckless.
C.
The Amended Complaint Does Not Adequately Allege that DTTC
Made Material Misstatements
When a Section 10(b) claim is alleged against an independent auditor
without a motive to commit fraud on the basis of its audit opinions, the inquiry
with respect to scienter is “substantially the same[]” as the inquiry with respect to
whether the auditor made a material misstatement.236 Plaintiffs’ arguments that
DTTC made false or misleading statements are identical to their arguments that
235
In re Scottish Re Group Secs. Litig., 524 F. Supp. 2d at 385 (quotation
marks and citations omitted).
236
In re Lehman Bros. Secs. and Erisa Litig., 799 F. Supp. 2d 258, 302
(S.D.N.Y. 2011).
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DTTC acted with scienter.237 Therefore, for the reasons stated above, and for
substantially the reasons given in the Dismissal Opinion, the Amended Complaint
does not adequately allege that DTTC’s audit opinions contained material
misstatements.238
D.
Leave to Amend
The Second Circuit has committed the decision of whether to grant
leave to amend a complaint that is deficient under the PSLRA to the sound
discretion of the district courts.239 Rule 15(a) creates a policy favoring amendment,
but leave to amend should be denied where the proposed amendment would be
futile.240
The only circuit courts to address the issue have held that, by
heightening the pleading burden and imposing a stay of discovery, the PSLRA
restricts the circumstances in which amendment should be granted.241 I concur.
237
See Opp. Mem. at 19-25.
238
See In re Longtop, 2012 WL 5512176, at *10.
239
See Campo, 371 Fed. App’x at 218.
240
See Dougherty, 282 F.3d at 87.
241
See Miller v. Champion Enters. Inc., 346 F.3d 660 (6th Cir. 2003)
(stating that “we think it is correct to interpret the PSLRA as restricting the ability
of plaintiffs to amend their complaint, and thus as limiting the scope of [Rule
15(a)]”); In re NAHC Inc. Secs. Litig., 306 F.3d 1314, 1332 (3d Cir. 2002)
(affirming district court’s denial of leave to amend, and stating that “the PSLRA
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Because the PSLRA increases the probability that a proposed amendment will be
futile, I conclude that amendment should be granted less freely when a complaint
subject to the PSLRA is dismissed.
Unlike most plaintiffs subject to the PSLRA, the Plaintiffs have had
access to copious discovery in crafting the Amended Complaint. Despite this fact,
their claim against DTTC still falls well short of stating a claim. Moreover, the
Amended Complaint still suffers from the same defects laboriously identified in
the Dismissal Opinion; principal among them, fraud by hindsight. In these
circumstances, granting further leave to amend would be futile. Accordingly, leave
to amend is denied.
E.
Findings Under Rule 11
The PSLRA provides for mandatory findings under Rule 11, with a
presumption that the appropriate sanction for violations of that Rule is an award of
fees and costs.242 These findings are to be made “upon final adjudication of the
action . . . .”243 That time has not yet come. Accordingly, I defer making findings
under Rule 11 until this action has been finally adjudicated.
limits the application of [Rule] 15 in securities fraud cases”).
242
See 15 U.S.C. § 78u-4(c).
243
Id. § 78u-4(c)(1).
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V.
CONCLUSION
For the foregoing reasons, defendant DTTC's motion to dismiss is
granted. The Clerk of Court is directed to close this motion (Docket No. 128).
SO ORDERED:
Shira A. Scheindlin
U.S.D.J.
Dated:
New York, New York
April 8, 2013
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-Appearances-
Counsel for Lead Plaintiffs:
Kimberly A. Justice, Esq.
John A. Kehoe, Esq.
John J. Gross, Esq.
Kessler Topaz Meltzer & Check, LLP (PA)
280 King of Prussia Road
Radnor, Pennsylvania 19087
(610) 667-7706
Daniel L. Berger, Esq.
Jeff A. Almeida, Esq.
Deborah A. Elman, Esq.
Reena S. Liebling, Esq.
Grant & Eisenhofer, P.A. (NY)
485 Lexington Avenue
29th Floor
New York, New York 10017
(646) 722-8500
Counsel for DTTC:
Gary F. Bendinger, Esq.
Gazeena K. Soni, Esq.
Sidley Austin LLP
787 Seventh Avenue
New York, New York 10019
(212) 839-5300
Michael Dana Warden, Esq.
Sidley Austin LLP
1501 K Street, N.W.
Washington, D.C. 20005
-71-
(202) 736-8080
David Andrew Gordon, Esq.
Sidley Austin LLP
One South Dearborn
Chicago, Illinois 60603
(312) 853-7159
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