Stemborowski v. DNTW Chartered Accountants, LLP et al
MEMORANDUM OPINION & ORDER: For the reasons stated above, Defendants' motion to dismiss is granted. The Clerk of the Court is directed to terminate the motion (Dkt. No. 47) and to close this case. (As further set forth in this Opinion) (Signed by Judge Paul G. Gardephe on 3/21/2016) (kl)
l.t( I (Q
UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
13 Civ. 4632 (PGG)
In re DNTW CHARTERED
OPINION & ORDER
PAUL G. GARDEPHE, U.S.D.J.:
This is a securities class action brought under Sections IO(b) and 20(a) of the
Securities and Exchange Act of 1934 (the "Exchange Act"). Plaintiffs purchased shares of
Subaye, Inc. and allege that the Company's auditor- Defendant DNTW Chartered Accountants
LLP - "knowingly turned a blind eye and deliberately disregarded ... obvious fraud at Subaye,"
(Consolidated Amended Class Action Cmplt. (Dkt. No. 33) ~ 5) (hereinafter Amended
Complaint), and "issued materially false and misleading 'clean' audit reports for Subaye's fiscal
year 2009 and 20 l 0 financial statements." (Id. if 3)
Pending before the Court is Defendants' motion to dismiss the Amended
Complaint. (Dkt. No. 47) For the reasons stated below, Defendants' motion will be granted.
Subaye is a Delaware corporation that purports to provide computing, online
media, and advertising services in China. (Amended Cmplt. (Dkt. No. 33) if 28) Between 2008
and 2010, Subaye reported "tremendous revenue growth," claiming that its sales in China grew
from $29.1 million in 2008 to $47.9 million in 2009.
74(g)(i)-(iii)) While overall
The following facts are drawn from the Amended Complaint (Dkt. No. 33), and are presumed
true for purposes of resolving Defendants' motion to dismiss. See Kassner v. 2nd Ave.
Delicatessen, Inc., 496 F.3d 229, 237 (2d Cir. 2007).
revenue dropped to $39. l million in 2010, Subaye reported that its online business grew by
In 2011, fraud at the Company was uncovered, and it became clear that Subaye's
claims about its revenue and customer base were false.
ilil irir 81-82, 106)
allegations against Subaye and its Chief Financial Officer - James Crane - were made, the value
of Subaye's stock fell significantly, causing losses to Plaintiffs. (Id. ifif 102-07, 117) Soon after,
Crane resigned as CFO. (Id.
In May 2013, the SEC sued Subaye and Crane for securities
fraud. (Id. ifif 33, 35)
In 2009 and 2010, while the fraud was ongoing at Subaye, Defendant DNTW
served as the Company's auditor.
ilil ir 3)
During this period, DNTW performed audits of
Subaye's financial statements. (lQJ Those audits covered 2008, 2009, and the fiscal year
ending on September 30, 2010.
ilil irir 37-38)
DNTW issued "clean" audit reports for these
Subaye' s 2009 audited financial statements include an $8.1 million asset labeled
"Deposits for Purchase of Inventoriable Assets." (Id.
9(b ), 51-53) Crane represented to
DNTW that these cash "deposits were made with consumer good companies to ensure 'just in
time' delivery of products sold from Subaye.com," and assured DNTW that the deposits were
ilil ifif 52, 74(c))
Subaye was "not a seller of consumer products," however,
and Crane never provided DNTW with sufficient evidence to demonstrate that the cash actually
ilib) DNTW nonetheless accepted Crane's explanation concerning the alleged $8.1
million in cash deposits.
ilib if 74(c)) In 2010, Subaye wrote off the $2.1 million remaining
balance of this alleged asset.
In 2010, Subaye recorded an $18.8 million asset on its balance sheet as "Cash
Held in Trust." (Id.
if 49) During the 2010 audit, Crane told DNTW that this $18.8 million in
cash "was held by Subaye's third-party sales agents to be used for marketing and promotional
expenses, as directed by the Company." ~ DNTW "asked Crane to produce documents to
support the existence of this cash, ... [but] Crane could not produce any bank account
statements, receipts or other direct proof." (Id.
if 50) "Instead, Crane produced contracts, said to
have been signed by the third-party sales agents, purporting to show a relationship between them
and Subaye." (IQ) Crane later admitted to DNTW, however, that Subaye had no control over
the cash allegedly being held by its third-party sales agents. (hl,_) DNTW "ultimately
determined that there was not sufficient evidence to account for the $18.8 million as an asset and
insisted that it instead be booked as a marketing expense." (Id. if 50(a))
On December 23, 2010, Subaye dismissed DNTW as its auditor and hired
PricewaterhouseCoopers Hong Kong ("PWC"). (Id. if 78) "PWC was able to quickly identify
that Subaye's financial statements were misstated." (Id. if 79) On April 7, 2011, PWC
announced its resignation as Subaye's auditor. (Id.
if 81) PWC
cited numerous reasons that called into question the legitimacy of Subaye's
business, namely inadequate documentation to substantiate the purported ...
marketing expense that purportedly was being held by Subaye's sales agents; the
existence of customers; commonalities between customers and vendors (i.e.,
customers were also vendors); and despite the millions of [dollars of] revenue
generated no evidence [that] Subaye [had] paid business tax in China.
On March 24, 2011, market analyst Geo Investing issued a report asserting that
Subaye's claimed 1,500 employees did not exist, that Subaye's alleged "cloud" products did not
exist, and that Subaye's stock was likely worthless. (Id.
Despite the apparent magnitude of Subaye's fraud, DNTW had issued "clean"
audit reports for the Company's financial statements for 2008, 2009, and fiscal year 2010. (Id.
In DNTW's 2009 audit report, DNTW states that it conducted the audit
in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the
audits to obtain reasonable assurance about whether the financial statements are
free of material misstatement. The Company is not required to have, nor were we
engaged to perform, an audit of its internal control over financial reporting. Our
audits include consideration of internal control over financial reporting as a basis
for designing audit procedures that are appropriate in the circumstance, but not for
expressing an opinion on the effectiveness of the Company's internal control over
financial reporting. Accordingly, we express no such opinion. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Subaye, Inc.
and Subsidiaries, a Delaware corporation, as of September 30, 2009 and 2008,
and the results of its consolidated operations and comprehensive income,
stockholders' equity, and cash flows for the[se] years ... , in conformity with
accounting principles generally accepted in the United States of America.
37) (emphasis omitted)
DNTW' s 2010 audit report makes the same representations, except in its last
paragraph, which references only the Company's operations and cash flows:
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Subaye, Inc.
and Subsidiaries, a Delaware corporation, as of September 30, 2010 and 2009,
and the results of its operations and cash flows for the years then ended, in
conformity with accounting principles generally accepted in the United States of
Plaintiffs claim that DNTW's audit reports are "materially false and misleading,"
in that they "falsely state that DNTW had conducted its audits of Subaye 'in accordance with
standards of the Public Company Accounting Oversight Board (United States) ("PCAOB").'"
The PCAOB requires an auditor to, inter alia, (1) obtain "reasonable assurance"
about whether the financial statements are free of material misstatement WL ~ 37); (2) obtain
sufficient competent evidence to afford a "reasonable basis" for an opinion concerning the
audited financial statements (id.~ 47); (3) exercise due professional care (id. if 56); (4) establish
direct communication between itself and those entities or individuals providing confirmations of
financial transactions to "minimize the possibility that the results will be biased because of
interception and alteration of the confirmation requests or responses"
WL if 54); and (5) supervise
assistants that it hires to conduct an audit. (Id. ~ 46).
According to Plaintiffs, instead of following these standards, DNTW "knowingly
turned a blind eye and deliberately disregarded the obvious fraud at Subaye." (Id. ifif 4-5)
"DNTW knew ... that Subaye had ineffective disclosure and internal controls" and therefore
"knew that it could not simply rely on Subaye's management to provide [it] with documents or
information in the performance of its audit of Subaye." (Id. if 6) Nonetheless, Plaintiffs allege
that DNTW "relied almost exclusively on Subaye and its management, particularly Crane.''
10) In particular, DNTW "relied solely on purported bank statements that were provided to
DNTW by Subaye's management" rather than "testing Subaye's cash through confirmations to
Clih if 8)
DNTW did not, for example, confirm the existence of (1) the $8.l million in cash
that Subaye listed as "Deposits for Purchase oflnventoriable Assets"
Wh iii! 9(b), 51-53), or (2)
the $18.8 million that Subaye attempted to record as "Cash Held in Trust."
Clih ~if 9(a), 49-50).
DNTW also "performed no further procedures ... after discovering" that: (1) ten accounts
receivable confirmations were received within eleven days after the requests for confirmation
had been mailed out Wh ~if 9( e), 61 ); (2) four accounts receivable confirmations were faxed from
Subaye's bookkeeper and not from Subaye's customers
fuL ifif 9(c), 55); (3) $6.7 million of
Subaye's $7.1 million cash balance as of September 30, 2010 2 was deposited into Subaye's
account during the last week of fiscal year 2010 ~if 9(d)); and (4) "Subaye kept changing its
business model, but ... continued to increase sales." (Id.
fl 9(f)). Finally, DNTW did not have
any Chinese-speaking auditors on staff (id. ~ I 0), and did not properly supervise its contracted
China-based assistants. (Id.
According to Plaintiffs, PWC uncovered the fraud at Subaye with ease when it
utilized audit procedures required by PCAOB standards.
M ~if 11-12)
In May 2013, the SEC brought an enforcement proceeding against Subaye and
Crane alleging securities fraud. (Id. ~if 33-35) The SEC concluded that (1) Subaye had no
verifiable assets; (2) the people Subaye claimed as customers had no such relationship with it;
(3) Subaye's offices were empty; and (4) Subaye was "'an imaginary business."'
In May 2014, the SEC issued a cease and desist order3 against DNTW partners
Bryce Walker and Spence Walker.
40-44) Bryce Walker served as the firm's
engagement partner for DNTW's audit of Subaye's 2010 financial statements. (Id. ii 23) Spence
Walker served as the firm's engagement partner for DNTW's audits and reviews of Subaye's
financial statements for 2007 through the third quarter of 2010. (Id.
ii 24) Spence Walker was
The Amended Complaint twice states that Subaye's cash balance was $7.1 million "as of
September 30, 2012." (See id. ifii 9(d), 74(e)) The correct date is September 30, 2010, however,
given that Plaintiffs allege that Subaye received $6.7 million of the total $7.1 million cash
balance "during the final week of fiscal year 2010." (@ The correct date is stated elsewhere in
the Amended Complaint. See id.~ 60 ("$6.7 million ofSubaye's $7.1 million cash balance as of
September 30, 2010 resulted from deposits into Subaye's accounts during the last seven days of
See Order Instituting Public Administrative and Cease-And-Desist Proceedings Pursuant to
Sections 4C and 21C of the Securities Exchange Act of 1934 and Rule 102(e) of the
Commission's Rules of Practice, Making Findings, and Imposing Remedial Sanctions and a
Cease-And-Desist Order. (Arn. Cmplt. (Dkt. No. 33), Ex. I)
also the quality review partner for Subaye' s 20 I 0 audit. (Id.) The SEC (1) directed Bryce and
Spence Walker to cease and desist from any future violations of Section l 3(a) of the Exchange
Act and Rule 13a-l, and Regulation SX-Rule-2-02(b)(l); (2) prohibited bothmen from
appearing or practicing before the SEC for a period of time; and (3) imposed fines, with joint and
several liability. (Id.
Plaintiffs filed this action on July 3, 2013. (Cmplt. (Dkt. No. I)) On September
3, 2013, Plaintiffs moved to consolidate a related action 4 with the instant action and for the
appointment of lead plaintiff and lead counsel. (Dkt. No. I 0) Defendants did not oppose
consolidation; accordingly, this Court ordered the two cases consolidated for all purposes (Dkt.
No. 17), and permitted Plaintiffs to file a Consolidated Class Action Complaint. (Dkt. No. 16)
That complaint was filed on December 2, 2013. (Dkt. No. 18) On December 13, 2013, Plaintiffs
filed the Corrected Consolidated Class Action Complaint (the "Prior Complaint"). (Dkt. No. 21)
On March 18, 2014, Defendants moved to dismiss the Prior Complaint. (Dkt. No.
22) Defendants argued that Plaintiffs had not sufficiently alleged (I) scienter under Section
IO(b), or (2) a misrepresentation by DNTW. (Def. Br. (Dkt. No. 24) at 5-8) Defendants further
argued that because the Section IO(b) claim fails, the control person claim under Section 20(a)
must also be dismissed. (ML at 7-8)
On March 30, 2015, this Court granted Defendants' motion to dismiss the Prior
Complaint on the grounds that Plaintiffs had not sufficiently alleged scienter under Section
IO(b). 5 In re DNTW Chartered Accountants Sec. Litig., 96 F. Supp. 3d 155, 163-69 (S.D.N.Y.
The other action is Dyke v. DNTW Chartered Accountants, LLP and John and Jane Does 1-5,
13 Civ. 5120 (PGG).
Havmg found that Plaintiffs had not adequately alleged scienter, this Court did not reach the
2015). This Court granted Plaintiffs leave to file an amended complaint. Id. at 170.
On May 11, 2015, Plaintiffs filed the Amended Complaint (Dkt. No. 33), and on
August 20, 2015, Defendants filed a motion to dismiss the Amended Complaint. (Dkt. No. 47)
Defendants argue that Plaintiffs have still not sufficiently alleged sci enter under Section I O(b),
and that because the Section I O(b) claim fails, the control person claim under Section 20(a) must
also be dismissed. (Def. Br. (Dkt. No. 48) at 6-7)
Rule 12(b)(6) Standard
"To survive a motion to dismiss, a complaint must contain sufficient factual
matter, accepted as true, to 'state a claim to relief that is plausible on its face.'" Ashcroft v.
Igbal, 556 U.S. 662, 678 (2009) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)).
"In considering a motion to dismiss ... the court is to accept as true all facts alleged in the
complaint," Kassner, 496 F.3d at 237 (citing Dougherty v. Town ofN. Hempstead Bd. of Zoning
Appeals, 282 F.3d 83, 87 (2d Cir. 2002)), and must "draw all reasonable inferences in favor of
the plaintiff." Id. (citing Fernandez v. Chertoff, 471 F.3d 45, 51 (2d Cir. 2006)).
A complaint is inadequately pied "if it tenders 'naked assertion[ s]' devoid of
'further factual enhancement,'" Igbal, 556 U.S. at 678 (quoting Twombly, 550 U.S. at 557), and
does not provide factual allegations sufficient "to give the defendant fair notice of what the claim
is and the grounds upon which it rests." Port Dock & Stone Corp. v. Oldcastle Ne., Inc., 507
F.3d 117, 121 (2d Cir. 2007) (citing Twombly, 550 U.S. at 555). "Threadbare recitals of the
issue of whether Plaintiffs had adequately pled a misrepresentation by DNTW. In re DNTW
Chartered Accountants Sec. Litig., 96 F. Supp. 3d 155, 169 n.4 (S.D.N.Y. 2015).
elements of a cause of action, supported by mere conclusory statements, do not suffice [to
establish entitlement to relief]." Iqbal, 556 U.S. at 678.
"In considering a motion to dismiss for failure to state a claim pursuant to Rule
l 2(b)(6), 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." 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); Hayden v. Cnty. ofNassau, 180 F.3d 42, 54 (2d Cir.
Heightened Pleading Standard for Securities Fraud Complaints
"A complaint alleging securities fraud pursuant to Section 1O(b) of the Securities
Exchange Act is subject to two heightened pleading standards." In re Gen. Elec. Co. Sec. Litig.,
857 F. Supp. 2d 367, 383 (S.D.N.Y. 2012). First, the complaint must satisfy Federal Rule of
Civil Procedure 9(b), which requires that the complaint "state with particularity the
circumstances constituting fraud .... " Fed. R. Civ. P. 9(b). Second, the complaint must meet
the pleading requirements of the Private Securities Litigation Reform Act (the "PSLRA"), 15
U.S.C. § 78u-4(b).
The heightened pleading requirement under Rule 9(b) "serves to provide a
defendant with fair notice of a plaintiffs claim, safeguard his reputation from improvident
charges of wrongdoing, and protect him against strike suits." ATSI Communications, Inc. v.
Shaar Fund, Ltd., 493 F.3d 87, 99 (2d Cir. 2007) (citing Rombach v. Chang, 355 F.3d 164, 171
(2d Cir. 2004)). Thus, a securities fraud complaint based on misstatements must '"(I) specify
the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where
and when the statements were made, and (4) explain why the statements were fraudulent.'"
Rombach, 355 F.3d at 170 (quoting Mills v. Polar Molecular Corp., 12 F.3d 1170, 1175 (2d Cir.
Under the PSLRA, a plaintiff must "state with particularity facts giving rise to a
strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u4(b)(2)(A); see Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551U.S.308, 313 (2007) ("The
PSLRA requires plaintiffs to state with particularity both the facts constituting the alleged
violation, and the facts evidencing scienter, i.e., the defendant's intention 'to deceive,
manipulate, or defraud.'" (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 & n.12
(1976))). "To qualify as 'strong' within the intendment of [the PSLRA] ... an inference of
scienter must be more than merely plausible or reasonable-it must be cogent and at least as
compelling as any opposing inference ofnonfraudulent intent." Tellabs, 551 U.S. at 314; see
also id. ("[T]o determine whether a complaint's scienter allegations can survive threshold
inspection for sufficiency, a court governed by [the PSLRA] must engage in a comparative
evaluation; it must consider, not only inferences urged by the plaintiff ... but also competing
inferences rationally drawn from the facts alleged."). "A complaint will survive ... 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." Id. at 324.
PLAINTIFFS' ALLEGATIONS OF SCIENTER IN
THE AMENDED COMPLAINT ARE INSUFFICIENT
To establish scienter, "[t]he PSLRA requires plaintiffs to state with particularity
... the facts evidencing ... the defendant's intention 'to deceive, manipulate, or defraud."'
Tellabs, 551 U.S. at 313 (quoting Ernst & Ernst, 425 U.S. at 194). As discussed below, "[t]he
pleading requirements for auditor scienter are particularly stringent." Special Situations Fund III
OP, L.P. v. Deloitte Touche Tohmatsu CPA, Ltd., 33 F. Supp. 3d 401, 426 (S.D.N.Y. 2014)
(citing In re Advanced Battery Techs., Inc. Sec. Litig., 2012 WL 3758085, at *15 (S.D.N.Y.
Aug. 29, 2012) ("ABATI") ("Courts in this District have repeatedly recognized [that] '[t]he
standard for pleading auditor scienter is demanding."')).
"Plaintiffs may allege scienter by either (1) showing the.defendants' motive and
opportunity to perpetrate fraud, or (2) alleging 'strong circumstantial evidence of conscious
misbehavior or recklessness.'" Iowa Pub. Emp. Ret. Sys. v. Deloitte & Touche LLP, 919 F.
Supp. 2d 321, 331 (S.D.N.Y. 2013) ("IPERS") (emphasis in IPERS) (quoting In re Scottish Re
Grp. Sec. Litig., 524 F. Supp. 2d 370, 384 (S.D.N.Y. 2007)).
The Amended Complaint contains no substantial new aIIegations concerning
Defendants' motive and opportunity to perpetrate fraud. Accordingly, the Court considers below
whether Plaintiffs have proffered strong circumstantial evidence of conscious misbehavior or
Conscious Misbehavior or Recklessness
To establish scienter through proof of conscious misbehavior or recklessness
requires "far 'more than a misapplication of accounting principles."' IPERS, 919 F. Supp. 2d at
333 (quoting SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992)). "At the
pleading stage, the reckless conduct alleged by plaintiffs must be, 'at a minimum, "highly
unreasonable[,] ... represent[ing] 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.""' Id. at 333-34 (quoting Tabor v. Bodisen Biotech, Inc., 579 F.
Supp. 2d 438, 449 (S.D.N.Y. 2008) (quoting In re Carter-Wallace, Inc., Sec. Litig., 220 F.3d 36,
39 (2d Cir. 2000))) (alterations in IPERS). "Such recklessness cannot be shown with [accounting
standard] violations alone." In re China Organic, 2013 WL 5434637, at *10 (S.D.N.Y. Sept. 30,
2013) (citing Stephenson v. PricewaterhouseCoopers, LLP, 768 F. Supp. 2d 562, 568 (S.D.N.Y.
2011) affd, 482 F. App'x 618 (2d Cir. 2012); In re Longtop Fin. Techs. Ltd. Sec. Litig., 910 F.
Supp. 2d 561, 574 (S.D.N.Y. 2012)).
"[F]or an independent auditor, the conduct 'must, in fact, approximate an actual
intent to aid in the fraud being perpetrated by the audited company,' as, for example, when a
defendant conducts an audit so deficient as to amount to no audit at all, or disregards signs of
fraud so obvious that the defendant must have been aware of them." In re Advanced Battery
Techs., Inc., 781 F.3d 638, 644 (2d Cir. 2015) ("ABAT II") (quoting Rothman v. Gregor, 220
F.3d 81, 98 (2d Cir. 2000), and citing Gould v. Winstar Commc'ns, Inc., 692 F.3d 148, 160-61
(2d Cir. 2012)); see also Rothman, 220 F.3d at 98 ("For 'recklessness on the part of a nonfiduciary 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." It must, in fact, approximate an actual intent to aid in the fraud being perpetrated by the
audited company'" (quoting Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120-21 (2d Cir.
1982))). "Mere 'allegations of GAAP violations or accounting irregularities,' or even a lack of
due diligence, will not state a securities fraud claim absent 'evidence of corresponding fraudulent
intent."' ABAT II, 781 F.3d at 644 (quoting Novak v. Kasaks, 216 F.3d 300, 309 (2d Cir. 2000),
and citing S. Cherry St., LLC v. Hennessee Grp. LLC, 573 F.3d 98, 112 (2d Cir. 2009)).
Where a plaintiff attempts to plead scienter through allegations demonstrating
conscious misbehavior, those allegations must show "deliberate illegal behavior" by the auditor.
In re China Organic, 2013 WL 5434637, at* 10. The auditor's conduct "must reflect accounting
judgments that 'no reasonable accountant would have made ... if confronted with the same
facts,"' see IPERS, 919 F. Supp. 2d at 333 (quoting Price Waterhouse, 797 F. Supp. at 1240),
and the accounting practices employed must be "'so deficient that the audit amounted to no audit
at all,' meaning 'an egregious refusal to see the obvious, or to investigate the doubtful.'" Id.
(quoting Price Waterhouse, 797 F. Supp. at 1240).
Another "crucial limitation to ... recklessness-based scienter is the insufficiency
of allegations of'fraud by hindsight."' Id. at 334 (quoting Novak, 216 F.3d at 309). The
allegations may not "rest on a post hoc ergo propter hoc approach to the complex issue of
scienter." Id. at 335.
"'[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 in wrongdoing to the detriment of its investors."' In re China
Organic, 2013 WL 5434637, at* 10 (quoting In re Longtop Fin. Techs. Ltd. Sec. Litig., 910 F .
. Supp. 2d at 574 (quoting In re IMAX Sec. Litig., 587 F. Supp. 2d 471, 483 (S.D.N.Y. 2008)))
(second alteration in In re Longtop Fin. Techs. Ltd. Sec. Litig.). However, courts have declined
to "extend IOb-5 liability to instances where an auditor fails to investigate certain red flags that,
while themselves ... not indicative of actual fraud, could, if pursued, [have led] to the discovery
of fraud." Iowa Pub. Emp. Ret. Sys. v. Deloitte & Touche LLP, 973 F. Supp. 2d 459, 465
(S.D.N.Y. 2013) ("IPERS II").
Defendants argue that - in evaluating whether Plaintiffs have sufficiently alleged
scienter - this Court should consider only new allegations in the Amended Complaint, and
should disregard allegations previously asserted in the Prior Complaint and repeated in the
Amended Complaint. (Def. Reply Br. (Dkt. No. 51) at 5) In dismissing the Prior Complaint,
this Court found that its allegations were insufficient to establish scienter. See In re DNTW
Chartered Accountants Sec. Litig., 96 F. Supp. 3d at 169 ("The inference that DNTW was
engaged in deliberate illegal activity or acted with recklessness approximating intent to aid
Subaye's fraud is not as compelling as the competing inferences .... Accordingly, Plaintiffs have
not sufficiently alleged scienter." (citing Tellabs, 551 U.S. at 314)). Defendants note that under
the law of the case doctrine, '"when a court has ruled on an issue, that decision should generally
be adhered to by that court in subsequent stages of the same case unless cogent and compelling
reasons militate otherwise.'" In re LIBOR-Based Fin. Instruments Antitrust Litig., 27 F. Supp.
3d 447, 473 (S.D.N.Y. 2014) (quoting Johnson v. Holder, 564 F.3d 95, 99 (2d Cir. 2009),
reconsideration denied, 2014 WL 6488219 (S.D.N.Y. Nov. 18, 2014)). Accordingly, Defendants
argue that this Court should not reconsider any allegations that it previously found insufficient to
establish scienter. (Def. Reply Br. (Dkt. No. 51) at 5)
In determining whether Plaintiffs have sufficiently alleged scienter, however,
"[t]he inquiry ... is whether all of the facts alleged, taken collectively, give rise to a strong
inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that
standard." Tellabs, 551 U.S. at 322-23 (emphasis in Tellabs) (citing Abrams v. Baker Hughes
Inc., 292 F.3d 424, 431 (5th Cir. 2002); Gompper v. VISX, Inc., 298 F.3d 893, 897 (9th Cir.
2002)); see also Athale v. SinoTech Energy Ltd., 2014 WL 687218, at *6 (S.D.N.Y. Feb. 21,
2014) ("The Court must examine the allegations both individually and in aggregate, keeping in
mind that such allegations may lend support to an inference of scienter even if they are not, on
their own, sufficient to establish it."); IPERS, 919 F. Supp. 2d at 331-32 ("[C]ourts must
examine such red flags in the 'aggregate,' which prevents defendants from 'secur[ ing] dismissal
by cherry-picking only those allegations susceptible to rebuttal and disregarding the remainder.'"
(quoting In re Refco, Inc. Sec. Litig., 503 F. Supp. 2d 611, 658 (S.D.N.Y. 2007))). Accordingly,
this Court has considered all of the allegations in the Amended Complaint - whether repeated
from the Prior Complaint or made for the first time - in determining whether Plaintiffs have
sufficiently pled scienter.
Plaintiffs claim that DNTW (1) ignored "red flags" that should have put it on
notice of Subaye's fraud (Pltf. Br. (Dkt. No. 52) at 7); (2) "failed to adjust [its] audit procedures
in light of the red flags"; and (3) "actually eased [its] audit procedures" in violation of PCAOB
standards. (Mb at 8)
Plaintiffs Have Not Established Scienter
Under a "Red Flags" Theory
In the Amended Complaint, Plaintiffs identify certain "red flags" of fraud that
they previously asserted in the Prior Complaint. These alleged "red flags" are: (I) Subaye's
"inconsistent and implausible explanations" regarding the cash generated by Subaye's business
(Prior Cmplt. (Dkt. No. 21) ~~ 6, 52; Am. Cmplt. (Dkt. No. 33) ~ 9(a)); (2) Subaye's relatively
small cash balance, and its continued revenue growth while its business was in transition (Prior
Cmplt. (Dkt. No. 21) ~~ 41-45; Am. Cmplt. (Dkt. No. 33) ~ 74(g)); (3) the $8.1 million in
refundable cash deposits (Prior Cmplt. (Dkt. No. 21) ~~ 49-50; Am. Cmplt. (Dkt. No. 33) ~ 9(b));
and (4) the $18.8 million in cash, later booked as a marketing expense. (Prior Cmplt. (Dkt. No.
21) ~ 47; Am. Cmplt. (Dkt. No. 33) ~~ 49-50)
Plaintiffs also allege the following new "red flags" in the Amended Complaint:
that (1) $6.7 million of Subaye's $7.1 million cash balance as of September 30, 2010- the end of
the fiscal year- was deposited into Subaye's account during the last week of September (Am.
Cmplt. (Dkt. No. 33) ~ 9(d)); (2) ten accounts receivable confirmations were received within
eleven days after the requests for confirmation were mailed out@.~ 9(e)); and (3) four accounts
receivable confirmations were faxed to DNTW by Subaye's bookkeepers rather than by
Subaye's customers. (Id.
As to the $6.7 million deposited into Subaye's account in the last week of fiscal
year 2010, Plaintiffs argue that "[m]aterial late-in-the-reporting period adjustments support a
claim of sci enter." (Pltf. Br. (Dkt. No. 52) at 22) The Court acknowledges that a pattern of
material transactions occurring at the end of a quarter or other reporting period can support a
claim of scienter. See In re AOL Time Warner, Inc. Sec. & "ERISA" Litig., 381 F. Supp. 2d
192, 240 (S.D.N.Y. 2004) ("[P]laintiff alleges that [the auditor] ignored the fact that material
amounts of advertising revenue came in at the end of each quarter just in time to permit [the
client] to hit its advertising revenue targets. Such late-in-the-quarter revenue recognition has
been found sufficient to support a claim of scienter." (citing In re Homestore.com, Inc. Sec.
Litig., 252 F. Supp. 2d 1018, 1044 (C.D. Cal. 2003) (finding that "the most significant of these
red flags was the fact that on numerous occasions, major transactions took place within the last
few days of the quarter''))). Plaintiffs allege no such pattern here, however. Instead, Plaintiffs
point to one occasion in which a material amount of revenue was received at the end of a fiscal
year. Plaintiffs have cited no case suggesting that such a one-time event constitutes a "red flag"
As to the accounts receivable confirmations, Plaintiffs argue that the quick return
of all of these confirmations constitutes a "red flag", noting that Bryce Walker "recognized how
unusual [it] was" for all audit confirmations to be returned so quickly. (Pltf. Br. (Dkt. No. 52) at
13) Plaintiffs complain that Walker "fail[ed] to exercise the adequate level of professional
skepticism that was required based on the circumstances" and "never performed additional
procedures." (Am. Cmplt. (Dkt. No. 33) if 61) Plaintiffs also assert that the fact that four of the
accounts receivable confirmations were returned by Subaye's bookkeepers rather than by
Subaye's customers was a "red flag" of fraud. (lsL if 74(d))
To proceed under a "red flags" theory, however, Plaintiffs must show that DNTW
disregarded "red flags" that are themselves "indicative of actual fraud." See IPERS II, 973 F.
Supp. _2d at 465 (declining "to extend I Ob--5 liability to instances where an auditor fails to
investigate certain red flags that, while themselves ... not indicative of actual fraud, could, if
pursued, [have led] to the discovery of fraud"); see also Stephenson, 768 F. Supp. 2d at 573
("[T]he Second Circuit has affirmed the dismissal of a complaint 'replete with allegations that [a
firm] "would" have learned the truth as to those aspects of the [fraudulent] funds if [it] had
performed the "due diligence" it promised' and that '[i]f [the firm] had asked various questions
earlier, it would have further questioned the [fraudulent fund's] financial records or recognized
the need to ask further questions."' (quoting S. Cherry St., LLC, 573 F.3d at 112) (alterations in
Stephenson)); In re Tremont Sec. Law, State Law & Ins. Litig., 703 F. Supp. 2d 362, 370
(S.D.N. Y. 20 I 0) ("[M]erely alleging that the auditor had access to the information by which it
could have discovered the fraud is not sufficient." (citing Rothman, 220 F.3d at 98)).
Here, the manner in which the accounts receivable confirmations were returned to
DNTW is not itself indicative of actual fraud. Plaintiffs in effect acknowledge this, when they
criticize Bryce Walker for not exercising greater "professional skepticism" in connection with
the confirmations. (Am. Cmplt. (Dkt. No. 33) if 61) Asserting that someone should have
exercised greater "professional skepticism" is not tantamount to saying that he or she ignored
obvious indications of actual fraud, or engaged in conduct that approximates an actual intent to
aid in fraud. Rothman, 220 F.3d at 98. At most, Plaintiffs' allegations regarding the
confirmations suggest that if DNTW had exercised greater skepticism or performed further
procedures, it potentially could have discovered the fraud. Such allegations are not sufficient to
allege scienter under a "red flags" theory, however. 6
The new "red flags" alleged in the Amended Complaint - even when considered
with the allegations drawn from the Prior Complaint - fall far short of the "especially stringent
standard" for alleging conscious misbehavior or recklessness. Special Situations Fund III QP,
L.P., 33 F. Supp. 3d at 429. The Amended Complaint does not sufficiently allege scienter under
a "red flags" theory.
DNTW's Audits Were Not So Deficient as to Establish Scienter
Plaintiffs contend that DNTW's violation of PCAOB standards, and "loosen[ing]
[of its] auditing procedures," resulted in audits that were so deficient as to establish sci enter.
(Pltf. Br. (Dkt. No. 52) at 7-8)
The Amended Complaint re-asserts the following alleged deficiencies in DNTW's
audit procedures: (1) DNTW was aware of problems with Subaye's internal controls but
nevertheless "relied almost exclusively on Subaye and its management, particularly Crane"
(Prior Cmplt. (Dkt. No. 21) irir 6-7; Am. Cmplt. (Dkt. No. 33) if~ 6, IO); and (2) DNTW had no
Chinese-speaking auditors on staff. (Prior Cmplt. (Dkt. No. 21) if 83; Am. Cmplt. (Dkt. No. 33)
Plaintiffs also assert that Bryce Walker and DNTW's China-based assistants have given
inconsistent accounts as to the handling of the accounts receivable confirmations. (Am. Cmplt.
(Dkt. No. 33) ~ 9(c)) Plaintiffs state that "Bryce Walker testified to the SEC that it was DNTW's
contracted assistants in China that handled these confirmations. However, those same assistants
told the SEC they did not have any involvement with the accounts receivable confirmations."
(hL) Plaintiffs have pied that "DNTW's audit work papers contain copies ofretumed accounts
receivable confirmations," however (iQ. if 55), and the fact that there is "conflicting evidence of
how those confirmations were sent out and received by the auditors" (!sh) does not demonstrate
that DNTW ignored obvious signs of fraud. See S. Cherry St., LLC, 573 F.3d at 109. Instead,
the conflicting evidence supports an inference that DNTW performed a negligent and shoddy
The Amended Complaint also contains the following new alleged deficiencies:
(1) DNTW obtained bank statements from Subaye's management rather than from the bank
beginning wit~ the 2009 audit, "even though PCAOB standards state that audit evidence is more
reliable when it is obtained from independent sources" (Am. Cmplt. (Dkt. No. 33) if 8); and (2)
DNTW inadequately supervised the contracted China-based assistants. (ilh 146) The Amended
Complaint also notes that the SEC found that DNTW's audits were not conducted in accordance
with PCAOB standards. (bl ifif 40-44)
Mere violation of accounting standards is not sufficient to establish scienter,
however. See In re Lehman Bros. Sec. & Erisa Litig., 2015 WL 5514692, at* 12 (S.D.N.Y. Sept.
18, 2015) ("GAAP violations, accounting irregularities, and a lack of due diligence are not
sufficient" to establish scienter (citing ABAT II, 781 F.3d at 644)); In re Winstar Commc'ns,
2006 WL 473885, at *11 (S.D.N.Y. Feb. 27, 2006) ("[G]eneral allegations regarding the
existence of GAAP and GAAS violations and that the accounting firm was in possession of
relevant documentation will not suffice to establish scienter" (citing Decker, 681 F.2d at 120)).
Rather, plaintiffs must show conduct that "'approximate[s] an actual intent to aid in the fraud
being perpetrated by the audited company.'" Rothman, 220 F .3d at 98 (quoting Decker, 681
F .2d at 121 ). Allegations of accounting irregularities must therefore be accompanied by facts
suggesting corresponding fraudulent intent. See id. ("Although the Complaint alleged that [the
auditor] had violated various GAAP provisions, those allegations, 'without corresponding
fraudulent intent,' do not suffice 'to state a securities fraud claim."' (quoting Chill v. Gen. Elec.
Co., 101F.3d263, 270 (2d Cir. 1996))); Athale, 2014 WL 687218, at *10 ("As Plaintiffs
themselves recognize, 'allegations of GAAP violations or accounting irregularities, standing
alone, are insufficient,' and must be 'coupled with evidence of corresponding fraudulent intent'
in order to state a securities fraud claim." (quoting Novak, 216 F.3d at 309)).
To meet this standard, "a plaintiff must proffer facts suggesting far more than
simply an audit that could have been better. Rather, the audit must have been so shoddy that it
was a 'pretend' audit - an audit that in effect was not performed at all." In re Puda Coal Sec.
Inc., Litig., 30 F. Supp. 3d 230, 248 (S.D.N.Y. 2014) (citing Rothman, 220 F.3d at 98).
Plaintiffs' allegations do not come close to meeting this demanding standard.
With respect to Plaintiffs' claim that DNTW "relied almost exclusively on Subaye
and its management" (Am. Cmplt. (Dkt. No. 33) ~ I 0) - including by obtaining bank statements
from Subaye's management rather than the bank (id.~ 8) - this assertion is contradicted by
Plaintiffs' other allegations, as this Court pointed out in dismissing the Prior Complaint. In
granting Defendants' motion to dismiss, this Court found that "DNTW did not 'rely solely' on
[management's] representations." In re DNTW Chartered Accountants Sec. Litig., 96 F. Supp.
3d at 167. With respect to the $18.8 million "Cash Held in Trust" asset, for example, this Court
found - based on Plaintiffs' allegations - that "(I) DNTW would not permit Subaye to carry
these funds as cash on its balance sheet absent corroborating documentation; and (2) as a result
of DNTW's apparently persistent questions, the alleged $18 .8 million asset was converted to an
The Amended Complaint provides new evidence that DNTW did not rely
exclusively on representations made by Subaye's management: according to Plaintiffs, DNTW's
work papers show that on November 19, 2010, DNTW sent out accounts receivable
confirmations to independent parties. (Am. Cmplt. (Dkt. No. 33) if 61) Acknowledging that in
2009 DNTW began obtaining bank statements from management, the allegations of the
Amended Complaint - when considered as a whole - do not demonstrate that DNTW "relied
almost exclusively" on Subaye's representations. 7 (See Am. Cmplt. (Dkt. No. 33) iii! 6, IO)
With respect to the SEC's findings concerning deficiencies in DNTW's audits including violations of PCAOB standards (see id. ifil 40-44) - this Court recognizes that
Plaintiffs can make use of such material in attempting to plead scienter. See,~' Vanleeuwen v.
Keyuan Petrochemicals, Inc., 2014 WL 3891351, at *4 (S.D.N.Y. Aug. 8, 2014) ("'[T]here is
nothing improper about utilizing information contained in an SEC complaint as evidence to
support private claims under the PSLRA' .... Plaintiffs appropriately relied on the SEC
complaint in pleading scienter.... "(quoting In re Fannie Mae 2008 Sec. Litig., 891 F. Supp. 2d
458, 471 (S.D.N.Y. 2012))); S.E.C. v. Lee, 720 F. Supp. 2d 305, 341 (S.D.N.Y. 2010) (same).
The fact that this Court can consider information drawn from the SEC's cease and desist order
does not mean, of course, that such information will necessarily be sufficient to establish
scienter. See Glazer Capital Mgmt., LP v. Magistri, 549 F.3d 736, 748 (9th Cir. 2008) (finding
that settlement agreements with SEC "were not sufficient to meet [scienter] pleading
Similarly, while Plaintiffs complain that Defendants should have exercised greater supervision
over the China-based assistants (Am. Cmplt. (Dkt. No. 33) if 46), the fact that DNTW employed
China-based assistants tends to undercut Plaintiffs' criticism that Defendants' audits were
deficient because DNTW had no Chinese-speaking auditors on staff. (Id. if 10) Based on the
allegations of the Amended Complaint, it is apparent that Defendants attempted to mitigate the
lack of Chinese-speaking staff auditors by hiring Chinese assistants in China, where Subaye
purportedly conducted its business.
8 Plaintiffs cite Omanoffv. Patrizio & Zhao LLC, 2015 WL 1472566, at *5 (D.N.J. Mar. 31,
2015) for the proposition that an SEC regulatory action premised on negligent conduct can be
relied on by private plaintiffs attempting to plead scienter. (See Pltf. Br. (Dkt. No. 52) at 26) In
Omanoff, however, the court did no more than reject defendants' argument that the SEC's
negligence-based action established that the defendants had not committed fraud. See Omanoff,
2015 WL 1472566, at *5 ("Defendants argue that the SEC's initiation of an action against
[Defendants] premised upon negligence, not fraud, demonstrates that Defendants did not engage
in fraud. Defendants fail, however, to provide the Court with any authority supporting the
Here, the SEC's cease and desist order lists several deficiencies in DNTW's
audits. The factual findings in the cease and desist order mirror - rather than supplement Plaintiffs' allegations in the Amended Complaint, however. 9 Moreover, in discussing the legal
standards that Bryce and Spence Walker violated, the SEC's order indicates that the two men
committed either "intentional or reckless [conduct J" or "negligent conduct." (Am. Cmplt. (Dkt.
No. 33), Ex. 1 ~~ 33-35) Given that negligent conduct does not meet the standard for conscious
misbehavior or recklessness, see S. Cherry St., LLC, 573 F.3d at 109, the SEC's cease and desist
order does not establish that Defendants acted with scienter.
In dismissing the Prior Complaint, this Court found that Plaintiffs had "plead[ed]
ample facts demonstrating that DNTW was negligent." In re DNTW Chartered Accountants
Sec. Litig., 96 F. Supp. 3d at 167. The new allegations in the Amended Complaint continue in
this same vein. The deficiencies in DNTW's audits are not so severe, however, that they
constitute "'pretend' audit[s] - ... audit[s] that in effect w[ere] not performed at all." In re Puda
Coal Sec. Inc., Litig., 30 F. Supp. 3d at 248 (citing Rothman, 220 F.3d at 98). Nor do the
deficiencies suggest "deliberate illegal behavior" by DNTW. In re China Organic, 2013 WL
5434637, at* 10.
proposition that a private party may only bring a Section 1O(b) claim against an accounting firm
ifthe SEC first initiates an action sounding in fraud.").
The SEC' s cease and desist order cites the following facts, all of which Plaintiffs have pled in
the Amended Complaint: (I) the $8.1 million asset labeled "Deposits for Purchase of
Inventoriable Assets"; (2) the $18.8 million "Cash Held in Trust" asset; (3) the inadequate
supervision of China-based assistants; (4) bank statements obtained from management rather
than the bank; (5) the inconsistency in witness accounts as to whether DNTW or the China-based
assistants were responsible for handling accounts receivable confirmations; (6) the $6.7 million
in cash received at the end of fiscal year 2010; and (7) the receipt often accounts receivable
confirmations within eleven days after the requests for confirmation were sent out. Compare
Am. Cmplt. (Dkt. No. 33), Ex. I, ~ii 1-32) with id.,~~ 8-9, 46)
The inference that DNTW was engaged in deliberate illegal activity or acted with
recklessness approximating an intent to aid Subaye's fraud is not as compelling as the competing
inferences. It is more plausible that DNTW was itself fooled, or that it simply performed
shoddy, negligent audits. Accordingly, Plaintiffs have not sufficiently alleged scienter. See
Tellabs, 551 U.S. at 314 ("To qualify as 'strong' within the intendment of [the PSLRA], ... an
inference of scienter must be more than merely plausible or reasonable - it must be cogent and at
least as compelling as any opposing inference of nonfraudulent intent."); see also id. ("[T]o
determine whether a complaint's scienter allegations can survive threshold inspection for
sufficiency, a court governed by [the PSLRA] must engage in a comparative evaluation; it must
consider, not only inferences urged by the plaintiff ... but also competing inferences rationally
drawn from the facts alleged."). Plaintiffs' Section 1O(b) claim will be dismissed. 10
CONTROL PERSON LIABILITY
The Amended Complaint includes a claim for violation of Section 20(a) of the
Exchange Act, 15 U.S.C. § 78t(a). A claim for control person liability under Section 20(a) is
"necessarily predicated on a primary violation of securities law." Rombach, 355 F.3d at 177-78.
Because this Court finds that Plaintiffs have not adequately pied a violation of the securities
laws, their Section 20(a) claim will be dismissed.
Having found that Plaintiffs have not sufficiently alleged scienter, this Court does not reach
the issue of whether the Amended Complaint adequately pleads a misrepresentation by DNTW.
For the reasons stated above, Defendants' motion to dismiss is granted. The
Clerk of the Court is directed to terminate the motion (Dkt. No. 47) and to close this case.
Dated: New York, New York
March 21, 2016
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