Friday, December 16, 2016

Allegations in complaint led to an inference of, at worst, laziness

By R. Jason Howard, J.D.

A Second Circuit panel has affirmed a lower court’s judgment in a class action in favor of auditors of Subaye, Inc., a publicly traded but fake company, because the plaintiffs failed to adequately plead scienter or that there was a primary violation by a control person (In re DNTW Chartered Accountant Securities Litigation, December 15, 2016).

Auditors. Subaye, a company that purportedly provided computing, online media, and advertising services in China, used the auditing services of DNTW Chartered Accountants LLP in 2009 and 2010, during which DNTW issued “clean” audit reports in spite of the fact that Subaye had no real business operations. Allegations were made that DNTW ignored “red flags” that should have put it on notice of the fraud and that DNTW failed to adjust its audit procedures in light of the red flags and actually eased its audit procedures in violation of PCAOB standards.

District court. The amended complaint, the district court explained, contained no new allegations concerning the auditor’s motive and opportunity to perpetrate fraud. Moreover, the court found that Subaye purchasers did not sufficiently plead the existence of scienter under a “red flags” theory, where the court said plaintiffs must show that DNTW disregarded red flags that were themselves indicative of actual fraud. The court dismissed the plaintiff’s Section 10(b) and Rule 10b-5 claim for failure to adequately plead scienter and the Section 20(a) claim for failure to plead a primary violation.

Second Circuit. Citing to the PSLRA, the panel noted that the plaintiff’s complaint did not clear the high bar set for pleading an auditor defendant’s scienter. The plaintiff’s primary allegation was that DNTW was aware of Subaye’s deficient internal controls over financial reporting but DNTW expressly disclaimed providing any opinion concerning Subaye’s internal controls and sometimes sought confirmation of Subaye’s finances from outside sources.

The more compelling inference to be drawn from these allegations, the panel suggested, is that DNTW tried, albeit inadequately, to compensate for Subaye’s deficient internal controls and did not intend to aid in Subaye’s fraud.

Yet another allegation was dismissed by the court when it explained that DNTW’s insistence that an asset that Subaye could not provide adequate documentation for be booked as a marketing expense, undermined the plaintiff’s assertions in showing scienter because it demonstrated that DNTW, through its audit, opposed Subaye’s efforts to misrepresent its financial position.

The remaining allegations did not establish the required “strong inference” of scienter; even when considered in the aggregate, the allegations did not approximate an actual intent to aid in Subaye’s fraud. Instead, the allegations led “to an inference of, at worst, laziness,” the panel concluded.

The district court properly dismissed the claims and the judgment was affirmed.

The case is No. 16-1168.