Puskala v. Koss Corporation et al
Filing
53
DECISION AND ORDER signed by Judge Lynn Adelman on 7/28/11 granting 33 Motion to Dismiss; granting in part and denying in part 35 Motion to Dismiss. The § 10(b) and Rule 10b-5 claim against Michael J. Koss is dismissed. The § 10(b) and Rule 10b-5 claim against Koss Corporation and the § 20(a) claim against Michael J. Koss survive. (cc: all counsel) (dm)
UNITED STATES DISTRICT COURT
EASTERN DISTRICT OF WISCONSIN
DAVID A. PUSKALA, individually and on
behalf of all others similarly situated,
Plaintiff,
v.
Case No. 10-C-0041
KOSS CORPORATION, MICHAEL J. KOSS,
SUJATA (“Sue”) SACHDEVA, and GRANT
THORNTON, LLP
Defendants.
______________________________________________________________________
DECISION AND ORDER
This is a proposed class action alleging securities fraud in violation of § 10(b) of the
Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities and Exchange
Commission (“SEC”) Rule 10b-5, 17 C.F.R. § 240.10b-5. Plaintiff also brings claims
asserting “control person” liability under § 20(a) of the Act, 15 U.S.C. § 78t(a). The suit
arises out of the embezzlement of over $30 million from the Koss Corporation by Sujata
“Sue” Sachdeva, the company’s vice president of finance, secretary and principal
accounting officer. Plaintiff names Sachdeva as a defendant, but he also names the
company, its CEO, and its former accounting firm as defendants.
The latter three
defendants have moved to dismiss the amended class action complaint for failure to state
a claim for relief against them. Fed R. Civ. P. 12(b)(6).
I. BACKGROUND
The facts stated in this opinion are taken from the amended class action complaint,
which incorporates by reference Sachdeva’s plea agreement, the SEC’s civil complaint
against her, and Koss Corporation’s civil complaint against Sachdeva and Koss’s former
accounting firm, Grant Thornton LLP. I assume for purposes of the present motions that
the facts stated in the complaint, and in the documents incorporated by reference into the
complaint, are true. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322 (2007).
Between 2004 and December 2009, Sachdeva embezzled more than $30 million
from Koss and used the stolen funds to purchase luxury goods, including designer clothing,
jewelry, furs and household items. Sachdeva stole money from the company through use
of cashier’s checks, wire transfers and traveler’s checks. In an effort to conceal the
missing funds, Sachdeva devised an elaborate scheme of accounting fraud. With the
assistance of Koss’s senior accountant, Sachdeva made false accounting entries in the
company’s books that were designed to hide the cash she had embezzled. The various
techniques Sachdeva employed are detailed in the SEC complaint attached to plaintiff’s
complaint, but in general the scheme involved making adjustments to various company
accounts to offset the diverted cash. For example, in one series of false entries, Sachdeva
reduced a company cash account by $750,000, an amount Sachdeva had stolen. To
ensure that the accounts balanced and that no one noticed the missing cash, Sachdeva
made corresponding accounting entries that increased inventory by $500,000, decreased
liabilities by $50,000, and decreased sales by $200,000. These entries made it appear as
though Koss had devoted $750,000 to legitimate business transactions. Sachdeva made
countless other such entries in an effort to avoid detection. However, to prevent the
company’s outside accountants from noticing what she was doing, Sachdeva refrained
from making fraudulent transfers from certain company accounts during the month of June,
when Grant Thornton was conducting its audit.
2
Sachdeva’s fraud was uncovered on December 18, 2009, when American Express
notified Koss that funds were being wired from a company bank account to pay for
expenses on Sachdeva’s personal credit card. On December 21, 2009, Koss asked
NASDAQ to halt trading of its stock pending investigation of the unauthorized transactions.
That same day, Sachdeva was arrested after admitting to the theft and the accounting
fraud. She would eventually plead guilty in federal court to six counts of wire fraud and be
sentenced to eleven years’ imprisonment. When Koss’s stock resumed trading on January
11, 2010, the share price declined by approximately 24%.
The false accounting entries that Sachdeva made to conceal her theft were used
to prepare Koss’s financial statements. This, in turn, rendered all of the SEC filings – the
10-Ks and 10-Qs – issued by Koss during the period in which the fraud was ongoing
materially false. Ultimately, Koss filed amended and restated financial statements for fiscal
years 2008, 2009 and 2010. Both Sachdeva and the company’s CEO, Michael J. Koss,
signed the false SEC reports and attested to the accuracy of the false financial statements.
The company’s outside auditors, Grant Thornton LLP, certified that the false financial
statements fairly presented Koss’s financial position.
Plaintiff seeks to represent a class of investors in Koss’s stock who suffered
economic losses as a result of purchasing Koss stock in reliance on the false information
contained in the company’s SEC filings. Plaintiff sues Sachdeva under § 10(b) and Rule
10b-5 and as a control person under § 20(a). Sachdeva has not moved to dismiss the
complaint. However, plaintiff also sues the company itself, Michael J. Koss, and Grant
Thornton LLP. Plaintiff does not contend that any of these defendants knew about
Sachdeva’s embezzlement or the accounting fraud she used to cover it up. However,
3
plaintiff contends that the company is vicariously liable for Sachdeva’s fraud, that Michael
Koss committed securities fraud by recklessly certifying that the company’s financial
statements were accurate, and that Grant Thornton committed securities fraud by
recklessly representing that Koss’s financial statements fairly presented Koss’s financial
position. Plaintiff also argues that Michael Koss is liable as a control person. The
company, Koss and Grant Thornton move to dismiss these claims.
II. DISCUSSION
As noted, plaintiff brings claims under Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934. Section 10(b) forbids the use or employment of any deceptive
device in connection with the purchase or sale of any security. 15 U.S.C. § 78j(b). Rule
10b-5 implements this provision by forbidding the making of any “untrue statement of a
material fact” or the omission of any material fact needed to make a statement not
misleading. 17 C.F.R. § 240.10b-5. The Supreme Court has determined that § 10(b) and
Rule 10b-5 imply a private cause of action for securities fraud. E.g., Matrixx Initiatives, Inc.
v. Siracusano, __ U.S. __, 131 S. Ct. 1309, 1317 (2011). In a typical § 10(b) private action,
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.” Id. at 1317-18 (quoting Stoneridge Inv. Partners, LLC v.
Scientific–Atlanta, Inc., 552 U.S. 148, 157 (2008)).
Section 20(a) creates a form of secondary liability for violations of the securities
laws. It provides that any person who “controls, directly or indirectly, any person liable”
4
under the securities laws is jointly and severally liable with the controlled person for the
primary violation. 15 U.S.C. § 78t(a). To prevail on a § 20(a) claim, a plaintiff must first
demonstrate that the controlled person committed a primary violation, Pugh v. Tribune Co.,
521 F.3d 686, 693 (7th Cir. 2008), which in the present case means a violation of § 10(b)
and Rule 10b-5.
In the securities context, to survive a motion to dismiss under Federal Rule of Civil
Procedure 12(b)(6), a plaintiff must satisfy the heightened pleading requirements of the
Private Securities Litigation Reform Act of 1995 (“PSLRA”), 15 U.S.C. § 78u-4(b)(1)-(2).
The only heightened pleading requirement at issue in the present case is the requirement
that the plaintiff state with particularity “facts giving rise to a strong inference that the
defendant acted with the required state of mind.” Id. § 78u-4(b)(2)(A). Here, that means
pleading a strong inference of the defendant’s “scienter” in connection with the § 10(b) and
Rule 10b-5 claims. Scienter is the intent to deceive, manipulate or defraud, Ernst & Ernst
v. Hochfelder, 425 U.S. 185, 193 (1976), and to prove a defendant’s scienter a plaintiff
must prove that he either knew the statement was false or was reckless in disregarding a
substantial risk that it was false, Makor Issues & Rights, Ltd v. Tallabs Inc., 513 F.3d 702,
704 (7th Cir. 2008) (“Tellabs II”).
The defendants’ motions to dismiss raise four issues: (1) Is the company liable for
Sachdeva’s § 10(b) and Rule 10b-5 violations?
(2) Does the amended complaint
adequately plead Michael Koss’s scienter? (3) Does the amended complaint adequately
plead Grant Thornton LLP’s scienter? And (4) does the amended complaint state a § 20(a)
claim for control-person liability against Michael Koss?
5
A.
Liability of Koss Corporation
A corporation or other business entity acts only through its agents, and so a
corporation’s liability for securities fraud is determined by principles of agency law. In the
securities context, two agency-law concepts are relevant: respondeat superior and
apparent authority. Tellabs II, 513 F.3d at 707-08; In re Atlantic Financial Mgmt., Inc., 784
F.2d 29, 31-32 (1st Cir. 1986); William H. Kuehnle, Secondary Liability Under the Federal
Securities Laws – Aiding and Abetting, Conspiracy, Controlling Person, and Agency:
Common Law Principles and the Statutory Scheme, 14 J. Corp. L. 313, 367-70 (1988).1
Under respondeat superior, a “master” (employer) is liable for the torts of a “servant”
(employee) done while the servant is acting within the scope of employment. Kuehnle,
supra, at 368. However, when the servant does not act for the purpose of furthering his
master’s goals but is on a “frolic of his own,” the master is not liable. Tellabs II, 513 F.3d
at 708; Atlantic Financial, 784 F.2d at 32. Under the concept of apparent authority, a
principal is liable when an agent acting with apparent authority makes a statement on
which another relies. Kuehnle, supra, at 369. The agent has apparent authority when,
from the perspective of third parties, it appears that the corporation has vested the agent
with authority to make the statement, whether or not the corporation actually has done so.
Unlike respondeat-superior liability, a principal may be held liable for acts done by an agent
with apparent authority even if the agent acts entirely for his own purposes and not for the
purpose of serving the principal. Am. Soc’y of Mech. Eng’rs, Inc. v. Hydrolevel Corp., 456
1
A third concept – actual authority – could theoretically apply in the securities
context, but it rarely does in practice. See Atlantic Financial, 784 F.2d at 31.
6
U.S. 556, 566 (1982) (“ASME”); Atlantic Financial, 784 F.2d at 32; Wise v. Wachovia
Secs., LLC, 450 F.3d 265, 269 (7th Cir. 2006).
In the present case, Koss argues that it cannot be held liable for Sachdeva’s
securities fraud because Sachdeva committed the fraud to conceal her acts of
embezzlement, rather than to further the company’s goals. It is true that Sachdeva was
committing fraud against the company rather than on behalf of it, and that therefore her
fraud cannot be imputed to the company under respondeat superior. Tellabs II, 513 F.3d
at 708; Cenco Inc. v. Seidman & Seidman, 686 F.2d 449, 456 (7th Cir. 1982). But this
does not mean that Sachdeva’s fraud cannot be imputed to the company under principles
of apparent authority. Rather, as we have just seen, if an agent acts with apparent
authority a principal is liable for the agent’s fraud even though the agent acts solely to
benefit himself. ASME, 456 U.S. at 566. And in this case Sachdeva unquestionably acted
with apparent authority when she signed the company’s 10-Ks and 10-Qs, thereby
representing that the information they contained was accurate.2
2
Koss relies heavily on Tellabs II for the proposition that it cannot be held liable for
Sachdeva’s fraud if Sachdeva was acting in furtherance of her own goals rather than the
company’s. This is because Tellabs II states that “deliberate wrongs by an employee are
not imputed to his employer unless they are not only within the scope of his employment
but in attempted furtherance of the employer's goals.” 513 F.3d at 708. However, in
making this statement, the court was discussing liability based on respondeat superior
rather than apparent authority. The court’s example involved a “low-level employee” who,
in concealing his embezzlement, reported false information to his superiors, which caused
the superiors to unwittingly misrepresent the corporation’s assets to investors. The lowlevel employee would not have made any statements directly to investors, and so liability
could not have been based on the low-level employee’s apparent authority. The superiors
did not know they were reporting false information, and so they did not have scienter and
their apparent authority could not lead to liability. Liability would result if the low-level
employee’s scienter could be imputed to the corporation through respondeat superior,
thereby rendering the statements made by the superiors fraudulent. But this could happen
only if the employee had been acting in furtherance of the employer’s goals. In the present
7
Koss does not dispute that Sachdeva’s statements were made with apparent
authority. Instead, it argues that apparent authority cannot be used to impute liability for
securities fraud to a company. This argument is clearly wrong, as it is very nearly blackletter securities law that “[a] corporation is liable for statements by employees who have
apparent authority to make them.” Tellabs II, 513 F.3d at 708; accord Pugh v. Tribune Co.,
521 F.3d 686, 697 (7th Cir. 2008); Institutional Investors Group v. Avaya, Inc., 564 F.3d
242, 251-52 (3d Cir. 2009); Atlantic Financial, 784 F.2d at 32, 35; Kerbs v. Fall River
Indus., Inc., 502 F.2d 731, 741 (10th Cir. 1974), abrogated on other grounds by Central
Bank of Denver v. First Interstate Bank, 511 U.S. 164 (1994).3 Koss tries to get around this
principle by claiming that “apparent authority cannot be used to impute the element of
scienter.” (Reply Br. [Docket #47] at 3.) It is not clear whether Koss means to distinguish
between imputing liability for fraud to a principal and imputing scienter to a principal, but
in any case courts have explicitly held that “[t]he scienter of the senior controlling officers
of a corporation may be attributed to the corporation itself to establish liability as a primary
violator of § 10(b) and Rule 10b-5 when those senior officials were acting within the scope
of their apparent authority.” Adams v. Kinder-Morgan, Inc., 340 F.3d 1083, 1106-07 (10th
case, Sachdeva had both apparent authority and scienter, and so Koss is liable even
though Sachdeva was not acting in furtherance of Koss’s goals.
3
Some courts have found that control-person liability under § 20(a) of the Securities
Exchange Act of 1934 supercedes liability based on apparent authority and other commonlaw forms of liability in the securities context. See Hollinger v. Titan Capital Corp., 914
F.2d 1564, 1576-77 (1990) (en banc) (collecting cases). However, Koss does not argue
that § 20(a) displaces agency principles, and in any event the Seventh Circuit rejected that
argument long ago. See Fey v. Walston & Co., 493 F.2d 1036, 1051-53 (7th Cir. 1974);
see also Atlantic Financial, 784 F.2d at 30 (describing Fey as a case in which the Seventh
Circuit “held that section 20(a) does not constitute an exclusive substitute for vicarious
liability that might otherwise exist”).
8
Cir. 2003) (collecting cases and other authority supporting the quotation). Here, Sachdeva
was a senior corporate officer who made statements to the market while acting with
apparent authority, and therefore the company is liable for her fraud even though she was
not trying to further the company’s goals. Accordingly, the company’s motion to dismiss
will be denied.
B.
Liability of Michael J. Koss and Grant Thornton LLP under Section 10(b) and
Rule 10b-5
Both Michael J. Koss and Grant Thornton LLP move to dismiss the § 10(b) and Rule
10b-5 claims against them on the ground that plaintiff has failed to plead facts giving rise
to a strong inference of scienter, as required by the PSLRA, 15 U.S.C. § 78u-4(b)(2)(A).
Plaintiff concedes that neither Michael Koss nor Grant Thornton was aware of Sachdeva’s
theft and accounting fraud; however, he contends that they were both recklessly indifferent
to the truth of the statements they made about the accuracy of Koss’s financial statements.
Plaintiff’s theory against Michael Koss is that he acted recklessly when he signed Koss’s
10-Ks and 10-Qs; his theory against Grant Thornton is that it acted recklessly when it
certified that Koss’s financial statements fairly presented Koss’s financial position.
The Supreme Court has not yet decided whether recklessness satisfies the scienter
element in an action under Rule 10b-5. See Matrixx Initiatives, __ U.S. at __, 131 S. Ct.
at 1323. However, the Seventh Circuit has held that it does. Sundstrand Corp. v. Sun
Chem. Corp., 553 F.2d 1033, 1044-45 (7th Cir. 1977). Although there are various
formulations of the recklessness standard in the securities context, it is typically described
as involving “an extreme departure from the standards of ordinary care . . . to the extent
that the danger [of the statement’s misleading another] was either known to the defendant
9
or so obvious that the defendant must have been aware of it.” Tellabs II, 513 F.3d at 704.
Thus, the defendant is liable if he is actually aware of a danger of misleading but
consciously disregards it. However, because it is hard to prove that someone is actually
aware of a particular danger, a person is also liable if it can be shown that the danger was
so obvious that a reasonable person would have known about it. Tellabs II, 513 F.3d at
704 (“When the facts known to a person place him on notice of a risk, he cannot ignore the
facts and plead ignorance of the risk.”); AMPAT/Midwest, Inc. v. Ill. Tool Works, Inc., 896
F.2d 1035, 1042 (7th Cir. 1990) (a person cannot close his eyes to a risk that is obvious
even if he does not himself perceive that risk); Sundstrand Corp., 553 F.2d at 1045 (a
person is reckless when he disregards a danger of misleading that is “so obvious that any
reasonable man would be legally bound as knowing”). In this situation, the obviousness
of the risk is circumstantial evidence of the person’s awareness of it. See Tellabs II, 513
F.3d at 704 (“knowledge [of a risk] is inferable from gravity”); 1 Dan B. Dobbs, The Law of
Torts § 27, at p. 51 (Practitioner Treatise 2001) (“[i]f the risk is obvious enough, the trier
can infer that the defendant was in fact conscious of it, and if it is also a serious risk of
substantial harm, the trier of fact can find recklessness”). Accordingly, the recklessness
standard is satisfied when a person makes a statement under circumstances in which a
reasonable person having knowledge of the facts known to the defendant would realize
that his statement poses a substantial risk of misleading another.
Because this is a motion to dismiss under the PSLRA, at this stage of the
proceedings plaintiff’s burden is to plead with particularity facts giving rise to a strong
inference that Michael Koss and Grant Thornton LLP were recklessly indifferent to a
substantial risk of misleading investors. To satisfy this burden, plaintiff must plead enough
10
concrete facts to make an inference of recklessness “cogent and at least as compelling as
any opposing inference one could draw from the facts alleged.” Tellabs, 551 U.S. at 324.
To determine whether the inference of recklessness is “cogent and at least as compelling
as any opposing inference,” I compare the strength of the inference of recklessness to the
strength of any innocent explanation for the statement’s falsity. Unless the inference of
recklessness is at least as compelling as any innocent explanation, the motion to dismiss
must be granted. With these standards in mind, I turn to the specific allegations against
Michael Koss and Grant Thornton LLP.
1.
Michael J. Koss
Like Sachdeva, Michael J. Koss signed the company’s SEC reports and attested to
the accuracy of Koss’s financial statements. To adequately plead that Michael Koss was
reckless in doing these things, plaintiff’s burden is to point to facts known to Koss at the
time he signed the company’s financial statements giving rise to a substantial risk that such
statements were false. Plaintiff seeks to satisfy this burden by showing that Michael Koss
was aware of facts indicating that the company’s internal controls over its financialreporting practices were completely unreliable, such that no top executive at Koss could
have thought that the financial statements being produced by the company were
reasonably accurate.
Turning to the complaint to see whether this inference is cogent and at least as
compelling as innocent explanations, the first thing to notice is that the complaint pleads
no concrete facts about the actual condition of the company’s internal controls over
financial reporting during the period in which Sachdeva’s fraud was ongoing.
The
complaint identifies no specific deficiencies in the internal controls, and it does not identify
11
any particular anti-fraud measure that could have been taken but wasn’t.4 Instead, the
complaint rests on plaintiff’s assertion that because Sachdeva was able to embezzle more
than $30 million without detection over a period of four years, the controls must have been
seriously deficient and Michael Koss must have known that they were. This type of
argument was rejected by the Seventh Circuit in Pugh v. Tribune Co., 521 F.3d 686, 69495 (7th Cir. 2008) and Higginbotham v. Baxter International Inc., 495 F.3d 753, 759-60 (7th
Cir. 2007), and plaintiff does not even cite these cases in his brief, much less attempt to
distinguish them.5
What plaintiff in the present case is attempting to do – and what the plaintiffs in
Pugh and Higginbotham were attempting to do – is invoke a distorted form of res ipsa
4
Plaintiff does list eight ways in which Koss’s internal controls were circumvented
and seems to hold this list out as a list of specific deficiencies. (Br. in Opp. [Docket # 40]
at 21.) But a list of ways in which controls were circumvented is not a list of deficiencies
in those controls. Controls need not be bulletproof, and so the fact that a control was
circumvented does not mean it was deficient. Higginbotham v. Baxter Int’l Inc., 495 F.3d
753, 759-60 (7th Cir. 2007). In any event, plaintiff’s list is so vague that it doesn’t even hint
at any specific deficiency. For example, plaintiff states that internal controls were
circumvented in relation to “wire transfers and cashier’s checks” but does not identify any
internal controls that were or should have been in place to protect against a misuse of wire
transfers or cashier’s checks.
5
Plaintiff does cite cases from various courts standing for the proposition that the
size of a fraud can be used to draw an inference of scienter, but those cases do not involve
situations in which a corporate insider commits accounting fraud in order to conceal her
embezzlement. In the cases plaintiff cites, the accounting fraud was of the Enron variety,
in which the company employs fraudulent accounting practices in order to make the
company look more attractive to investors. When sued for fraud, the top managers plead
ignorance of the fraudulent accounting practices, but when the fraud is large, it is likely that
the managers knew what was going on, since the managers are likely to have known that
the company’s actual condition was substantially different than the condition indicated by
the financial statements. In contrast, when a corporate insider takes steps to conceal her
own theft and fraudulent accounting practices from the company, including its top
managers, the same inference concerning the managers’ knowledge cannot be drawn.
12
loquitur. In its ordinary form, res ipsa loquitur allows a plaintiff in a negligence case to
prevail by showing that, even if there is no direct evidence of the defendant’s negligence,
the circumstances of the accident indicate that it probably would not have occurred had the
defendant not been negligent. Clifford v. Crop Prod. Servs., Inc., 627 F.3d 268, 273 (7th
Cir. 2010); Aguirre v. Turner Constr. Co., 582 F.3d 808, 810-11 (7th Cir. 2009). To be able
to use this doctrine, it must be obvious that an accident of the type that injured the plaintiff
rarely occurs in the absence of negligence. Clifford, 627 F.3d at 273; Smoot v. Mazda
Motors of Am., Inc., 469 F.3d 675, 679-80 (7th Cir.2006). A typical example is where, after
surgery, a plaintiff discovers that a surgeon's sponge was left in his abdomen. Smoot, 469
F.3d at 680. In such a case, an ordinary person can reasonably infer without considering
additional evidence that someone in the operating room was negligent. In the securities
context, a plaintiff trying to use what I have called a distorted form of res ipsa loquitur is
essentially contending that it is obvious that a fraud such as the one that occurred rarely
happens in the absence of recklessness by the company’s managers (or an intent to
deceive), and that therefore no evidence of specific deficiencies in the company’s practices
needs to be identified.
In the present case, however, it is not at all obvious that a fraud such as Sachdeva’s
is unlikely to occur unless the company’s internal controls are so deficient that its
managers could not have had any belief in the accuracy of the company’s financial
statements. As the Seventh Circuit has recognized, “no system [of financial controls] is so
foolproof that it cannot be evaded. Top managers at any firm can affect how financial
results are reported.” Higginbotham, 495 F.3d at 760. Even if it were possible to construct
a foolproof system, the cost of the system might outweigh its benefits. “Spending $50
13
million to stop a $33 million fraud is no bargain.” Id. In this regard, plaintiff has not
pleaded any specific facts that tend to rule out the inference that Koss’s internal controls
were reasonably effective – in the sense that the cost of the controls did not outweigh their
expected benefits – but Sachdeva was able to use her position in the company to
circumvent them.6
Perhaps the size and duration of Sachdeva’s fraud gives rise to an inference that
Michael Koss was negligent in failing to supervise the company’s accounting practices. But
negligence is not recklessness. As explained, Koss could have been reckless only if he
attested to the accuracy of the company’s financial statements while he was in possession
of information giving rise to a substantial risk that the statements contained misleading
information. This means that he must have known that the company’s internal controls
were completely unreliable, not just that he was negligent in failing to ensure that effective
controls were in place. Even if the occurrence of the fraud could be used to infer that the
controls were subpar, it does not give rise to an inference that the controls were completely
unreliable and that Michael Koss knew it.7
6
Plaintiff does allege that “[a]n individual who has taken a basic online accounting
course would have detected Sachdeva’s embezzlement” (Am. Class Action Compl. ¶ 36),
but this is hyperbole rather than a concrete allegation capable of satisfying the PSLRA’s
pleading requirements, and so I disregard it.
7
Plaintiff points to Koss’s signature on the certifications required by the SarbanesOxley Act of 2002 as evidence of scienter. In signing these certifications, Koss
represented, among other things, that to the best of his knowledge the company had
disclosed all substantial weaknesses in its internal controls over financial reporting.
Although Koss’s certifications strengthen the inference that he would have been aware that
the company’s internal controls were completely unreliable, they do not strengthen the
inference that the controls were completely unreliable in the first place.
14
Thus, we have at least two innocent explanations that the complaint has failed to
rule out or make less compelling than the inference of recklessness: (1) that the company’s
internal controls were reasonably effective but Sachdeva was able to use her position in
the company to circumvent them, and (2) the controls were ineffective, but not so obviously
unreliable that a reasonable person could not believe in the truth of financial statements
produced by such controls. As explained, however, the issue under review is whether the
inference of recklessness is at least as compelling as opposing inferences, and so the
remaining question is whether either of the innocent explanations is more compelling than
the inference of recklessness. If not, then the claim against Michael Koss cannot be
dismissed.
I conclude that the innocent explanations are more compelling than the inference
of recklessness. This is because plaintiff has failed to offer any plausible explanation for
Michael Koss’s recklessness. Unlike simple negligence, recklessness involves consciously
disregarding an obvious risk of harm, and thus an inference of recklessness is less
compelling when there is no plausible explanation for a person’s reckless behavior. In the
present case, a plausible explanation might be that Koss had learned about Sachdeva’s
fraud and wanted to keep it under wraps in the hopes of straightening out the mess she
created before investors learned what had happened, but plaintiff closed the door on this
theory by pleading that Michael Koss did not learn about Sachdeva’s fraud until the market
did. (Am. Class Action Compl. ¶ 80.) Plaintiff has suggested no other motive for Koss to
have behaved recklessly.
In contrast, the innocent explanations are much more plausible. As discussed, it
is relatively easy for a top manager to affect how financial results are reported, and thus
15
the inference that Koss’s internal controls were adequate but Sachdeva was able to use
her position in the company to circumvent them is cogent. Likewise, negligence does not
require conscious disregard of a risk, and so the inference that Koss’s internal controls
were inadequate but Michael Koss was simply careless in failing to realize that they were
does not require much of an explanation to be cogent. It is easy enough to say that
Michael Koss was inattentive or that the deficiencies in the controls may have been difficult
to detect, even though they could have been detected had Koss exercised ordinary care.
Thus, taking the lack of an explanation for recklessness into account, the innocent
inferences must be deemed to be more compelling than the inference of scienter.
In reaching this conclusion, I am aware that courts have said that the absence of
allegations establishing a motive to commit securities fraud is not necessarily fatal to a
§ 10(b) claim. See Tellabs, 551 U.S. at 325. Here, however, the absence of allegations
establishing motive are fatal because plaintiff has pleaded no other facts supporting an
inference of recklessness. Had plaintiff, for example, specifically identified dozens of
obvious and serious flaws in Koss’s internal controls, then the lack of allegations
establishing motive might not have required dismissal. But plaintiff alleges nothing other
than the occurrence of the fraud itself, and to the extent the fraud’s occurrence can even
be said to give rise to an inference of recklessness in the first place, that inference
evaporates once we consider the lack of an explanation for Michael Koss’s alleged
reckless behavior. Accordingly, the § 10(b) and Rule 10b-5 claim against Michael Koss
must be dismissed.
16
2. Grant Thornton LLP
The false statements at issue in plaintiff’s claim against Grant Thornton LLP are the
firm’s annual certifications that Koss’s financial statements fairly presented the company’s
financial position. Also at issue are Grant Thornton’s statements that its audits were
performed in accordance with standards published by the Public Company Accounting
Oversight Board. These two sets of statements are closely related, and in the discussion
that follows I treat them collectively as a single representation that Grant Thornton had
performed a professional audit of Koss’s financial affairs and reached the conclusion that
Koss’s financial statements were accurate.
Like Michael Koss, Grant Thornton did not know about Sachdeva’s embezzlement
or accounting fraud, and thus plaintiff does not contend that Grant Thornton knew that the
financial statements did not fairly present Koss’s financial position. Rather, plaintiff
contends that Grant Thornton was reckless in disregarding a substantial risk that Koss’s
financial statements contained material misstatements caused by employee fraud. Grant
Thornton moves to dismiss on the ground that plaintiff has failed to plead facts giving rise
to a strong inference of its recklessness.8
8
Before proceeding to an analysis of plaintiff’s allegations of recklessness, I note
that plaintiff has not identified any individual agent of Grant Thornton who behaved
recklessly. As discussed above in connection with the liability of Koss Corporation,
corporate scienter is usually imputed to an entity through the acts of its agents. Thus,
because plaintiff has not pleaded that any of Grant Thornton’s agents were reckless, it is
arguable that plaintiff has failed to plead that Grant Thornton itself was reckless. However,
Grant Thornton has not moved to dismiss on this ground, choosing instead to argue that
plaintiff’s allegations fail to give rise to an inference of recklessness at all. I therefore
assume that when plaintiff speaks of the recklessness of Grant Thornton, he is referring
to some partner at Grant Thornton who was responsible for the audit of Koss’s financial
affairs. Cf. Tellabs II, 513 F.3d at 710 (noting that “it is possible to draw a strong inference
of corporate scienter without being able to name the individuals who concocted and
17
To show that Grant Thornton’s certifications of Koss’s financial statements were
reckless, plaintiff must show that at the time of the certifications Grant Thornton was in
possession of facts that would have caused a reasonable person in its position to
recognize a substantial risk that the financial statements did not fairly present Koss’s
financial position.
To satisfy this burden, plaintiff once again relies heavily on the
inferences that can be drawn from the mere occurrence of Sachdeva’s fraud. As I have
already explained, however, the mere occurrence of the fraud does not imply that the
failure to prevent or detect it was the result of recklessness. Pugh, 521 F.3d at 694-95;
Higginbotham, 495 F.3d at 759-60. The occurrence of the fraud is also consistent with
Grant Thornton’s having performed an adequate audit and Sachdeva’s succeeding in
thwarting Grant Thornton’s investigation. In this regard, published accounting standards
explicitly recognize that an employee can get away with fraud even when the outside
auditor conducts an adequate investigation. See Am. Inst. of Certified Public Accountants,
Statement on Auditing Standards No. 99, 8-9 (Oct. 2002) (“even a properly planned and
performed audit may not detect a material misstatement resulting from fraud”). And in this
case, plaintiff alleges that Sachdeva took steps to conceal her fraud from Grant Thornton,
including abstaining from making unauthorized transactions from company accounts during
the month of June, when Grant Thornton was conducting its audit. The occurrence of the
fraud is also consistent with Grant Thornton’s having been no worse than negligent in its
performance of the audit.
disseminated the fraud”).
18
In addition to relying on the occurrence of the fraud, plaintiff argues that Grant
Thornton “completely ignored” “numerous red flags” that called attention to Sachdeva’s
fraud. However, most of the supposed red flags are nothing more than aspects of the
fraud itself – i.e., the occurrence of unauthorized transactions and the circumvention of
internal controls. (Br. in Opp. [Docket #43] at 18-19.) A red flag is something that calls
attention to a fraud, not the fraud itself, and so most of plaintiff’s supposed red flags are
not actually red flags.
Still, plaintiff does allege a few specific shortcomings in Grant Thornton’s audit.
First, he alleges that Grant Thornton failed to take a sample of Koss’s cancelled checks
for the purpose of identifying the entities that endorsed the checks. Plaintiff alleges that
if Grant Thornton would have done this it would have seen that many checks were going
to retailers of luxury goods rather than to Koss’s business partners. Plaintiff also alleges
that Grant Thornton failed to cross-check Koss’s bank records against its internal journal
entries, failed to detect violations of Koss’s policy requiring all invoices over $5,000 to be
approved by the CEO, failed to detect violations of Koss’s policy requiring the CEO to sign
all accounts-payable checks, and failed to detect violations of Koss’s policy limiting the use
of wire transfers to certain kinds of inventory purchases. However, although these specific
failures suggest that Grant Thornton may have been negligent in conducting its audit,
plaintiff does not explain why these failures give rise to an inference of recklessness.
Plaintiff does not, for example, plead facts suggesting that any audit in which the auditor
does not confirm the identities of the entities that endorsed the company’s cancelled
checks is necessarily a sham rather than a true audit. The same goes for the other alleged
19
failures: why do these failures rise to the level of recklessness rather than stop at
negligence? Plaintiff does not say.
Plaintiff also contends that if American Express was able to uncover Sachdeva’s
fraud, Grant Thornton must have been reckless in failing to do so. However, American
Express did not immediately catch Sachdeva’s fraud. Rather, Sachdeva was able to pay
her American Express bills from Koss bank accounts for years before American Express
notified Koss of what was going on. Further, as plaintiff alleges, Sachdeva took steps to
conceal her fraud from Grant Thornton by refraining from making unauthorized withdrawals
from accounts Grant Thornton was likely to check. There is no indication that Sachdeva
tried to hide what she was doing from American Express. Finally, even if the fact that
American Express eventually uncovered the fraud suggests that Grant Thornton should
have uncovered it earlier, this does not mean that Grant Thornton was reckless. Again,
the most it suggests is that Grant Thornton was negligent.
Finally, as was the case with Michael Koss, plaintiff fails to show that Grant
Thornton had a motive to behave recklessly. Plaintiff points to the fact that Grant Thornton
earned more than $650,000 in fees from Koss, and he suggests that this gave Grant
Thornton an incentive to overlook Koss’s accounting violations. But this suggestion is at
odds with the fact that Sachdeva was using accounting violations to steal from Koss, rather
than to help Koss defraud investors. The usual case in which an accountant’s receipt of
fees is thought to provide a motive to overlook the company’s accounting fraud involves
a company that is using aggressive or fraudulent accounting practices to make the
company look more attractive to investors. In this situation, the accountant helps the
company enrich itself at the expense of investors so that the company will continue to use
20
the accountant’s services in the future. This line of reasoning has been criticized, see
DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990), but in this case it makes no
sense at all. Koss would have wanted Grant Thornton to detect Sachdeva’s theft (or a
theft by any other employee), and so Grant Thornton’s reckless failure to be on the lookout
for employee theft and accounting fraud would not have helped the company. If anything,
Grant Thornton’s receipt of substantial fees from Koss makes it less likely that it would
have behaved recklessly. It suggests that Grant Thornton would have wanted to perform
a careful audit to ensure that the stream of fees continued. As it happened, Grant
Thornton missed the fraud and was fired.
Accordingly, considering the allegations against Grant Thornton collectively, the
inference that Grant Thornton was reckless in certifying Koss’s financial statements is less
compelling than the inference that Grant Thornton was merely negligent in failing to detect
the fraud. Plaintiff has therefore failed to plead a strong inference of Grant Thornton’s
scienter, and so the claim against it will be dismissed.
3. Judicial Notice of Newspaper and Magazine Articles
As part of his § 10(b) and Rule 10b-5 claims against Michael Koss and Grant
Thornton, plaintiff asks that I take judicial notice of a number of items. Many of the items
are unobjectionable, and so I do take judicial notice of them. These items are a letter that
Michael Koss wrote to this court in connection with Sachdeva’s criminal case, data
reflecting Koss’s market capitalization, Koss’s SEC filings, and published accounting
standards. (See Sams Decl.[Docket #41] Exs. 2-3, 5-6.) However, the remaining items
are a magazine article and a newspaper article concerning Sachdeva, Koss and Grant
Thornton. Defendants object to these items.
21
The magazine article, which appeared in Milwaukee Magazine, discusses
Sachdeva’s background, personality, and lifestyle and provides a general overview of the
embezzlement.
See Mary Van De Kamp Nohl, The Diva , Milwaukee Magazine, Nov.
2010, at 58. Various anonymous sources are quoted, and their statements suggest that
Michael Koss was lax in his oversight of Sachdeva and the company’s accounting
practices. For instance, after noting that Michael Koss denied seeing the merchandise
Sachdeva had been buying, the article quotes an anonymous retailer as saying “I was only
[at Koss’s headquarters] three or four times a year, and I saw boxes of clothing stacked to
the ceiling in the office next door to hers.” Another retailer is quoted as saying that
Sachdeva “ran all over” Koss. The article also quotes an unnamed CFO as saying that
“several standard-type controls” could have “easily detected” Sachdeva’s fraud.
The newspaper article, which appeared in the Milwaukee Journal Sentinel, raises
questions about the quality of Grant Thornton’s audit. See Cary Spivak, Koss auditor faces
mountain of questions in fraud case, Milwaukee Journal Sentinel, March 29, 2010, at A1.
The article quotes a local accounting professor, who states that “[t]he fraud is so large, in
relation to the size of the company, that I have got to believe that is going to make it very
difficult for Grant Thornton to prove that they conducted an audit in accordance with
generally accepted auditing standards.” The professor goes on to state that although he
is not convinced that Grant Thornton did anything wrong, he would not want to be in its
shoes because the public’s perception will be that the auditors must have missed
something. The rest of the article is similar, noting that although no one knows whether
Grant Thornton’s audit was deficient, at the very least Grant Thornton has sustained an
injury to its reputation.
22
In asking that I take judicial notice of these articles, plaintiff claims that he is not
offering them for the truth of the matters stated, but only to show that they exist. But what
relevance does the articles’ existence have to the pending motions? All that their existence
tells us is that the subject matter of this case is newsworthy, which says nothing about the
defendants’ scienter. Moreover, when plaintiff cites the articles in his briefs, he is quite
clearly seeking to use them for the truth of the matters asserted, in that he points to the
events recounted in the articles as evidence of Koss’s and Grant Thornton’s recklessness.
(Br. in Opp. to Koss [Docket #40] at 18-19, 22; Br. in Opp. to Grant Thornton [Docket #43]
at 4-5.) Thus, plaintiff’s representation that he is not offering these articles for the truth of
their contents is simply false.
Recognizing plaintiff’s request to take judicial notice of these articles for what it really
is, it is beyond doubt that it must be denied. A court can take judicial notice of a fact only
when the fact is so indisputably true that requiring a party to present evidence at trial to
establish that fact would be a waste of time. Fed. R. Evid. 201(b); Galina v. INS, 213 F.3d
955, 958 (7th Cir. 2000). Thus, a court can take judicial notice of things like the geographic
location of a city or the fact that Latvia regained its independence from the Soviet Union
in 1991. Galina, 213 F.3d at 958. The facts stated in the articles are obviously not these
kinds of facts. Indeed, such facts would be among the most hotly contested facts in this
case were it to proceed to trial. Accordingly, plaintiff’s request is denied.
C.
Liability of Michael J. Koss as a Control Person
The final question is whether the § 20(a) claim against Michael Koss must be
dismissed. Section 20(a) provides that a person who “controls” any person liable under
the securities laws is jointly and severally liable for the violation “unless the controlling
23
person acted in good faith and did not directly or indirectly induce the act or acts
constituting the violation or cause of action.” See 15 U.S.C. § 78t(a). Plaintiff alleges that
Michael Koss is liable as a person who controlled Koss Corporation.
Control-person liability is a form of secondary liability, and to state a claim under §
20(a), a plaintiff must first adequately plead a primary violation of the securities laws by the
controlled person. See, e.g., Pugh, 521 F.3d at 693. In the present case, plaintiff has
satisfied this requirement by pleading that Koss Corporation is liable for Sachdeva’s
securities fraud under the doctrine of apparent authority. The plaintiff must also plead that
the defendant exercised control over the wrongdoer and had the power to control the
specific transaction that is alleged to give rise to liability. See Donohoe v. Consol.
Operating & Prod. Co., 30 F.3d 907, 911-12 (7th Cir. 1994).
Michael Koss does not
dispute that plaintiff has adequately pleaded that he exercised control over Koss
Corporation and that he had the power to control the financial-reporting and accounting
practices at the company, and so these elements are also satisfied.
In moving to dismiss the § 20(a) claim against him, Koss argues that plaintiff has
pleaded facts showing that he acted in good faith. As noted, if the defendant acted in good
faith and did not directly or indirectly induce the primary securities violation, he is not liable
even if he is shown to have controlled the primary violator.
However, as Koss
acknowledges, good faith is an affirmative defense rather than an element of plaintiff’s
case. Donohoe, 30 F.3d at 912. Thus, to state a claim, a plaintiff need not plead facts that
negate the good-faith defense. Instead, once the plaintiff pleads the primary violation and
that the defendant controlled the primary violator, his job is done. Xechem, Inc. v. BristolMyers Squibb Co., 372 F.3d 899, 901 (7th Cir. 2004) (“[P]laintiffs need not anticipate and
24
attempt to plead around all potential defenses. Complaints need not contain any
information about defenses and may not be dismissed for that omission.”) There is an
exception to this rule, however, which applies when the plaintiff pleads himself into an
impenetrable or ironclad affirmative defense. Foss v. Bear, Stearns & Co., 394 F.3d 540,
542 (7th Cir. 2005). When this happens, the court can dismiss the complaint for failure to
state a claim on the ground that the plaintiff has pleaded himself out of court. Xechem,
372 F.3d at 901 (“Only when the plaintiff pleads itself out of court – that is, admits all the
ingredients of an impenetrable defense – may a complaint that otherwise states a claim
be dismissed under Rule 12(b)(6).”).
Michael Koss contends that plaintiff has pleaded facts triggering the good-faith
defense by alleging that Koss “did not act with knowledge of Sachdeva’s fraud” (Am. Class
Action Compl. ¶ 80) and that the Koss board of directors – of which Michael Koss was a
member – did not “begin to become aware of the problems in Koss’ internal controls and
financial statements” until Sachdeva’s embezzlement was discovered (id. at ¶ 107). The
allegation that Michael Koss did not know of Sachdeva’s fraud is not sufficient to trigger
the good-faith defense, since a controlling person can be liable if he is reckless in failing
to prevent the primary violation. Donohoe, 30 F.3d at 912. As discussed above, plaintiff
contends that Michael Koss was reckless in failing to ensure that the company’s financial
statements did not contain misleading information. While plaintiff has not pleaded facts
giving rise to a strong inference that Koss acted recklessly, this does not affect the § 20(a)
claim because, as discussed, plaintiff is not required to plead facts negating the good-faith
defense. Instead, because plaintiff has sufficiently alleged the elements of a prima facie
case under § 20(a), plaintiff is entitled to gather additional facts during discovery, and in
25
doing so he may uncover information undercutting the good-faith defense. Although this
is something of a back door into discovery on the subject of Michael Koss’s scienter and
thus seems like an end run around the PSLRA, it is allowed. See Makor Issues & Rights,
Ltd. v. Tallabs, Inc., 437 F.3d 588, 605 (7th Cir. 2006); In re Nat’l Century Fin. Enters., Inc.,
504 F. Supp. 2d 287, 304 (S.D. Ohio 2007) (“The Court's decision to allow the Section
20(a) claims to go forward but to dismiss the Section 10(b) claim reflects the scheme
established by Congress. It has imposed a heightened pleading standard for a Section
10(b) claim but not for a Section 20(a) claim.” (Internal quotation marks and citation
omitted)).
A few words need to be said, however, about plaintiff’s allegation that the Koss
board of directors did not “become aware of problems in Koss’s internal controls and
financial statements” until after the discovery of Sachdeva’s embezzlement. (Am. Class
Action Compl. ¶ 107.) This comes dangerously close to an allegation that Michael Koss
was not reckless, and thus very nearly triggers the good-faith defense. Recall that
recklessness means either actual awareness of a risk or awareness of facts that would
cause a reasonable person to recognize an obvious risk. Tellabs II, 513 F.3d at 704. The
risk in this case is the risk that Koss’s financial statements contained misleading
information, and plaintiff is trying to prove an awareness of the risk by showing that Michael
Koss was aware that the company’s internal controls were completely unreliable. If the
Koss board of directors, which included Koss himself, was not “aware of the problems in
[the company’s] internal controls” until Sachdeva’s fraud was uncovered, then how could
Michael Koss have known that the company’s internal controls were completely unreliable
prior to that time?
26
I don’t think he could have, but this does not mean that plaintiff has pleaded himself
into the good-faith defense. The allegation about unawareness of problems in the internal
controls appears in the part of the complaint in which plaintiff is pleading his case against
Grant Thornton, and plaintiff’s claims against Michael Koss and Grant Thornton are
somewhat inconsistent with each other. With respect to Koss, plaintiff alleges that the
defects in the internal controls were so obvious that Koss must have known about them;
with respect to Grant Thornton, plaintiff alleges that Koss had been reasonably relying on
Grant Thornton to identify any defects in the company’s internal controls. Federal Rule of
Civil Procedure 8(d)(3) allows a party to “state as many separate claims or defenses as it
has, regardless of consistency,” and so the fact that the claims against Koss and Grant
Thornton are inconsistent does not mean that either or both of the claims must be
dismissed. What this means for present purposes is that facts pleaded in connection with
plaintiff’s claim against Grant Thornton can be disregarded when considering plaintiff’s
claim against Koss, and so in alleging as part of his claim against Grant Thornton that Koss
did not know about problems in the company’s internal controls until after the discovery of
Sachdeva’s fraud, plaintiff has not pleaded himself into the good-faith defense with respect
to Koss. Accordingly, plaintiff’s § 20(a) claim against Michael Koss will not be dismissed.
III. CONCLUSION
For the reasons stated, IT IS ORDERED that Koss Corporation and Michael J.
Koss’s motion to dismiss is GRANTED IN PART and DENIED IN PART. The § 10(b) and
Rule 10b-5 claim against Michael J. Koss is dismissed. The § 10(b) and Rule 10b-5 claim
against Koss Corporation and the § 20(a) claim against Michael J. Koss survive.
27
IT IS FURTHER ORDERED that Grant Thornton LLP’s motion to dismiss is
GRANTED.
Dated at Milwaukee, Wisconsin, this 28th day of July, 2011.
/s_________________________
LYNN ADELMAN
District Judge
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