Susan Hufnagle v. Rino International Corporation et al, No. 2:2010cv08695 - Document 258 (C.D. Cal. 2013)
Court Description: ORDER DENYING DEFENDANT FRAZER FROST MOTION TO DISMISS THIRD AMENDED COMPLAINT 247 by Judge Dean D. Pregerson . (lc). Modified on 8/1/2013 (lc).
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Susan Hufnagle v. Rino International Corporation et al Doc. 258 1 2 O 3 4 5 6 7 8 UNITED STATES DISTRICT COURT 9 CENTRAL DISTRICT OF CALIFORNIA 10 11 12 SUSAN HUFNAGLE, individually and on behalf of all others similarly situated, 13 Plaintiff, 14 15 16 17 18 v. RINO INTERNATIONAL CORPORATION, DEJON ZOU, JENNY LIUE, BEN WANG, LI YU, KENNITH C. JOHNSON, JIANPING QIU, ZIE QUAN, and ZEJIN LI, Defendants. ___________________________ ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) Case No. CV 10-08695 DDP (VBKx) ORDER DENYING DEFENDANT’S MOTION TO DISMISS THIRD AMENDED COMPLAINT [Dkt. No. 247] 19 20 Presently before the court is Defendant Frazer Frost, LLP 21 (“Frazer Frost” or “the Auditor”)’s Motion to Dismiss Plaintiff’s 22 Third Amended Complaint (“TAC”). 23 of the parties, the court is inclined to deny the motion and adopt 24 the following order. 25 I. 26 Having considered the submissions Background As explained in the court’s earlier orders, this case is a 27 purported class action alleging violations of the Securities 28 Exchange Act of 1934, 15 U.S.C. § 78 et seq. (the "Exchange Act") Dockets.Justia.com 1 brought on behalf of a class consisting of all persons and entities 2 who purchased publicly traded Rino International Corporation 3 (“Rino”) common stock and call options, and who sold put options of 4 Rino, between March 31, 2009 and November 17, 2010 (the "Class 5 Period"). 6 fraud regarding its industrial equipment business in China. 7 ¶¶ 4-5.) 8 overstated its revenue and profits, fabricated contracts with 9 nonexistent customers, understated its tax liabilities, and The TAC alleges that RINO engaged in a wide-ranging (TAC Plaintiff alleges, for example, that RINO grossly 10 concealed transactions between RINO and other companies owned by 11 RINO’s CEO’s relatives. 12 agreement, Plaintiff has dismissed all claims against all 13 Defendants, with the exception of Frazer Frost. 14 (TAC ¶ 5.) Pursuant to a settlement (Dkt. No. 235.) Plaintiff alleges that auditor Frazer Frost either knowingly 15 or recklessly ignored obvious signs of financial irregularities and 16 failed to follow generally accepted auditing standards in its 17 review of RINO’s financial statements. 18 204.) 19 opinions regarding RINO’s financial statements. 20 Plaintiff alleges that Frazer Frost’s audit opinion regarding 21 RINO’s 2009 annual report falsely represented that RINO’s financial 22 statements conformed with generally accepted accounting principles 23 (“GAAP”). 24 II. 25 (TAC ¶¶ 7-25, 42-51, 133- The TAC alleges that on March 31, 2010, Frazer issued false (TAC ¶ 134.) Specifically, Frazer Frost now moves to dismiss the TAC. Legal Standard A complaint will survive a motion to dismiss when it contains 26 “sufficient factual matter, accepted as true, to state a claim to 27 relief that is plausible on its face.” Ashcroft v. Iqbal, 556 U.S. 28 662, 678 (2009) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 2 1 570 (2007)). 2 “accept as true all allegations of material fact and must construe 3 those facts in the light most favorable to the plaintiff.” Resnick 4 v. Hayes, 213 F.3d 443, 447 (9th Cir. 2000). 5 need not include “detailed factual allegations,” it must offer 6 “more than an unadorned, the-defendant-unlawfully-harmed-me 7 accusation.” 8 allegations that are no more than a statement of a legal conclusion 9 “are not entitled to the assumption of truth.” Id. at 679. When considering a Rule 12(b)(6) motion, a court must Iqbal, 556 U.S. at 678. Although a complaint Conclusory allegations or In 10 other words, a pleading that merely offers “labels and 11 conclusions,” a “formulaic recitation of the elements,” or “naked 12 assertions” will not be sufficient to state a claim upon which 13 relief can be granted. 14 quotation marks omitted). 15 Id. at 678 (citations and internal “When there are well-pleaded factual allegations, a court should 16 assume their veracity and then determine whether they plausibly 17 give rise to an entitlement of relief.” Id. at 679. 18 must allege “plausible grounds to infer” that their claims rise 19 “above the speculative level.” Twombly, 550 U.S. at 555. 20 “Determining whether a complaint states a plausible claim for 21 relief” is a “context-specific task that requires the reviewing 22 court to draw on its judicial experience and common sense.” 23 556 U.S. at 679. 24 Plaintiffs Iqbal, To state a claim for securities fraud under Section 10(b) of 25 the Securities Exchange Act and Rule 10b-5 promulgated thereunder, 26 plaintiffs must plead particularized facts demonstrating “(1) a 27 material misrepresentation or omission of fact, (2) scienter, (3) a 28 connection with the purchase or sale of a security, (4) transaction 3 1 and loss causation, and (5) economic loss.” 2 Digimarc Corp., 552 F.3d 981, 990 (9th Cir. 2009). 3 alleging securities fraud under the 4 Reform Act of 1995 (“PSLRA”) must meet a heightened pleading 5 standard. 6 “[s]pecify each statement alleged to have been misleading, the 7 reason or reasons why the statement is misleading, and . . . state 8 with particularity facts giving rise to a strong inference that the 9 defendant acted with the required state of mind.” Zucco Partners, LLC v. A complaint Private Securities Litigation The PSLRA requires that any securities fraud claim 10 Section 78u-4(b)(1), (b)(2). 11 15 U.S.C. III. Discussion 12 A. 13 Defendant argues that Plaintiff has failed to plead Scienter 14 particularized facts supporting a strong inference of scienter. 15 When analyzing a defendant’s intent, courts must view complaints 16 holistically, and should deny a motion to dismiss if the inference 17 of scienter advanced by plaintiffs is "at least as compelling as 18 any opposing inference one could draw from the facts alleged." 19 Matrixx Initiatives, Inc. v. Siracusano, 141 S. Ct. 1309, 1324 20 (2011) (citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 21 U.S. 308, 324 (2007); see also New Mexico State Investment Council 22 v. Ernst & Young LLP, 641 F.3d 1089, 1095 (9th Cir. 2011) 23 (“NMSIC”).1 24 “accounting practices were so deficient that the audit amounted to 25 no audit at all, or an egregious refusal to see the obvious, or to In the auditing context, a plaintiff must show that 26 1 27 28 Where any individual allegation is sufficient to create a strong inference of scienter, the court need not necessarily conduct a “holistic” review of the allegations in their entirety. NMSIC, 641 F.3d at 1095 (citing Zucco, 552 F.3d at 991-992). 4 1 investigate the doubtful, or that the accounting judgments which 2 were made were such that no reasonable accountant would have made 3 the same decisions . . . .” 4 marks and citation omitted). 5 intent to deceive, will not suffice. 6 7 1. NMSCIC, 641 F.3d at 1098 (quotation Allegations of a poor audit, absent Id. Tax returns and multiple sets of books Plaintiff alleges that RINO kept two sets of corporate books, 8 and that Frazer had actual knowledge of this improper accounting. 9 Frazer approved RINO’s report that it had $192.6 million in revenue 10 and a $56.4 million profit in 2009 and $139.3 million in revenue 11 and $25.5 in profit for 2008. 12 tax returns, however, indicated 2009 revenue of $11.1 million and 13 profit of $80,000 and 2008 revenue of $15.7 million and profit of 14 $1.2 million. 15 return showed 2009 revenue of only $9 million. 16 the reports approved by Frazer listed revenues and profits between 17 ten and twenty times higher than the figures reported in RINO’s tax 18 documents. 19 documents and RINO’s financial statements indicates that RINO was 20 keeping two sets of books and providing inflated numbers to 21 investors. 22 Securities and Exchange Commission ultimately suspended trading in 23 RINO securities in part because of the existence of two separate 24 and materially different sets of corporate books and accounts. 25 (TAC ¶ 35.) (TAC ¶ 14.) (TAC ¶ 16.) RINO’s Chinese income RINO’s Chinese Value Added Tax (“VAT”) (TAC ¶ 15.) Thus, Plaintiff argues that the conflict between the tax (Reply at 10.) Indeed, the TAC alleges that the 26 The TAC further alleges that Frazer was aware of the 27 discrepancy between RINO’s tax returns and reported revenue, and 28 therefore knew that RINO was cooking the books to mislead 5 1 investors. 2 RINO’s management highlighting several “significant deficiencies” 3 in RINO’s internal financial controls. 4 noted that RINO was not current on its issuance or receipt of VAT 5 invoices, and explicitly stated that “[w]hen the Company files the 6 tax return with the Chinese Government Tax Bureau, the reportable 7 book amount does not agree with the tax return for both the VAT tax 8 return and income tax return.” 9 consider this conflict to be a “material weakness” in RINO’s (TAC ¶ 13.) On March 29, 2010, Frazer sent a letter to (Id.) (TAC, Ex. C.) This letter Nevertheless, Frazer did not 10 financial report. 11 that RINO change the way it accounted for VAT on both the sales and 12 purchase sides of RINO’s business. 13 (Id.) Frazer’s letter nevertheless suggested (Id.) The court must compare the both the innocent and malicious 14 inferences supported by the alleged facts. 15 1095. 16 financial statements, despite Frazer’s knowledge of the discrepancy 17 with the tax return numbers, supports the inference that Frazer 18 knew its opinion that RINO complied with GAAP to be false. 19 at 10-11.) 20 NMSIC, 641 F.3d at Plaintiff argues that Frazer’s decision to approve RINO’s (Replay Frazer contends that its recognition of the deficiency in 21 RINO’s figures demonstrates Frazer’s diligence, and that Frazer’s 22 decision to label the conflicting figures a “significant 23 deficiency” rather than a “material weakness” was the result of 24 considered professional judgment. 25 argues that the difference between the Chinese tax figures and 26 RINO’s reported income and profit numbers was the result of 27 differences between Chinese tax law and SEC accounting rules, which 28 attach tax liability at different stages of a transaction. (Opposition at 13-14.) 6 Frazer (Opp. 1 at 13.) 2 the way it handled VAT payments and receipts to address this 3 serious, but not fundamental, issue with its VAT accounting. 4 Frazer further argues that the difference between the tax returns 5 and SEC filings does not demonstrate the existence of two sets of 6 books because the returns referenced in and attached to the 7 complaint only apply to a single RINO subsidiary. 8 however, included figures from all RINO entities. 9 For this reason, Frazer asserts, it suggested RINO change Its SEC filing, The facts alleged support the inference that Frazer approved 10 fraudulent figures. 11 Frazer’s explicit identification of the accounting weakness and 12 suggestion of a course of action to remedy it. 13 alternative explanations for the competing revenue figures, 14 particularly the limited scope of the Chinese tax returns, lend 15 further weight to the innocent inference here. 16 minimal competence would be unlikely to ignore such a blatant 17 impropriety as maintaining two sets of books, yet at the same time 18 identify and criticize that improper practice. 19 of the differing reported financial figures, therefore, is not 20 alone sufficient to support a strong inference of scienter. 21 2. That inference, however, is at odds with The potential A fraudster of even Frazer’s knowledge Reliance Upon Nonexistent Contracts 22 RINO’s internal documents indicate that RINO earned $11.1 23 million from its contracts in 2009 and $15.75 million in 2008. 24 (TAC ¶ 98(e).) 25 in RINO’s tax forms and, like those figures, represent only a 26 fraction of the revenues stated in the financial report approved by 27 Frazer. 28 of completion” method to record revenue based on contracts that These figures are consistent with those indicated Plaintiff alleges that RINO improperly used a “percentage 7 1 were not finalized.2 2 Frazer not only knew that RINO improperly used percentage of 3 completion accounting, but affirmatively directed RINO to utilize 4 that method in ways that violated GAAP. 5 the TAC alleges that Frazer told RINO to include in its 2009 6 revenue contracts that were not signed or did not take effect until 7 2010, after the applicable reporting period. (TAC ¶ 10). The TAC further alleges that (TAC ¶ 11.) For example, (Id.) 8 The TAC further alleges that many of the RINO customers listed 9 in RINO’s report either did not exist or had not purchased goods or 10 services from RINO.3 11 that Frazer failed to adequately check the status of the supposed 12 customers and contracts, even though RINO’s CEO told Frazer that 13 some customer contracts were merely incomplete “framework 14 agreements,” and that “there were (sic) some uncertainty about 15 execution of the framework agreements.” 16 acknowledges, however, that Frazer did send some sort of 17 confirmation form to RINO’s purported customers. 18 (TAC ¶¶ 123, 167-179.) Plaintiffs contend (TAC ¶¶ 47, 170.) The TAC (TAC ¶ 176.) Plaintiff argues that auditing standards required Frazer to 19 conduct a certain type of investigation of RINO’s customers. 20 at 17; TAC ¶ 165). 21 Accounting Oversight Board (“PCAOB”) auditing standard sections AU (Opp. Specifically, the TAC cites to Public Company 22 23 24 25 26 2 Under the percentage of completion method, revenue on longterm projects is recognized based on the percentage of work completed to date. In re Daou Systems, Inc., 411 F.3d 1006, 101213 (9th Cir. 2005). 3 27 28 While Plaintiff argues that up to 40% of the listed customers did not purchase anything from RINO or did not exist, that figure appears to include listed customers that Plaintiff’s investigator was not able to contact. 8 1 311, 319, and 326.4 2 opposition specify the subsections of those lengthy auditing 3 standards with which Frazer failed to comply. 4 opposition makes no mention of AU sections 311, 319, or 326. 5 Instead, Plaintiff’s opposition conclusorily asserts, without 6 citation, that “PCAOB auditing standards for percentage of 7 completion accounting required that Frazer obtain confirmation of 8 more information that simply the amount the customer believed it 9 currently owed RINO.” Nowhere, however, does the TAC or Plaintiff’s (Opp. at 17.) Indeed, Plaintiff’s Though Plaintiff makes some 10 limited references to the American Institute of Certified Public 11 Accountant’s Construction Contractors Audit & Accounting Guide, 12 PCAOB standards make clear that such guides are recommendations, 13 not auditing standards. 14 alleged that Frazer could have performed a different or more 15 thorough investigation of RINO’s customers, Plaintiff has not 16 alleged any specific facts related to percentage of completion 17 accounting that alone indicate that Frazer violated accounting 18 standards or support a strong inference of scienter. 19 3. 20 AU § 150.05. Thus, while Plaintiff has Additional “red flags” and holistic review If no individual allegation in sufficient to support a strong 21 inference of scienter, the court must proceed to conduct a 22 “holistic” review of those same allegations. 23 1095. 24 combination, create a strong inference of recklessness or 25 intentional conduct. NMSIC, 641 F.3d at Allegations insufficient on their own may nevertheless, in Id. “[T]he more facts alleged that should 26 4 27 28 Neither party includes these auditing standards with their pleadings. AU sections 311, 319, and 326 have all been superseded, effective December 15, 2010, but remain available at www.pcaobus.org. 9 1 cause a reasonable auditor to investigate further before making a 2 representation, the more cogent and compelling a scienter inference 3 becomes.” 4 Id. at 1098. The irregularities described above, though insufficient to 5 establish scienter on their own, more readily support an inference 6 of wrongdoing when viewed as a whole, alongside other allegations. 7 Frazer Frost knew that the revenue and profit numbers reported on 8 RINO’s tax returns did not match the figures reported to investors. 9 The revenue numbers based on RINO’s purported contracts matched the 10 lower tax return numbers, not the higher figure approved by Frazer. 11 Regardless whether Frazer’s investigation of RINO customers 12 conformed to accounting standards, Frazer knew that RINO was 13 utilizing percentage of completion methods to reach its revenue 14 figures, in part because Frazer advised RINO to do just that. 15 Though Plaintiff has not identified any particular accounting 16 standard related to percentage of completion, to the extent that 17 Frazer advised RINO to count revenue from unsigned, unexecuted 18 contracts, the parties appear to agree that inclusion of such 19 revenue would be improper. 20 These are not the only allegations that might give rise to 21 suspicion. 22 exemption in 2008. 23 advanced $22 million in cash to two of its major suppliers of raw 24 materials. 25 purchases, or $79.4 million of raw materials, came from these two 26 suppliers alone. 27 by RINO’s CEO’s nephew, and had no phone number or website. 28 ¶¶ 106-107.) The TAC alleges that RINO claimed a 100% income tax (TAC ¶ 78(f).) (TAC ¶ 95.) By the end of 2008, RINO had (TAC ¶ 96.) (TAC ¶ 104.) In 2009, RINO 93% of RINO’s One of the two suppliers was owned (TAC Neither did the larger of the two suppliers, which 10 1 did not exist before 2007, had no revenue in 2009, and was owned by 2 RINO’s CEO’s mother. 3 had advanced over $34 million to these two suppliers.5 4 112.) 5 (TAC ¶¶ 108, 110.) By the end of 2009, RINO (TAC ¶ RINO was generous not only to its CEO’s relatives, but also to 6 the CEO himself. 7 report, RINO gave its CEO an interest-free, unsecured loan of $3.5 8 million for the purchase of a personal residence in California. 9 (TAC ¶ 131.) In 2009, as disclosed in the Frazer-approved As described above, Frazer has identified reasonable 10 inferences that could be drawn from certain individual allegations. 11 Frazer’s argument that the allegations regarding millions of 12 dollars in cash advances do not establish scienter because 13 Plaintiffs have failed to allege that such advances are “contrary 14 to standard Chinese business practices or were otherwise 15 commercially unreasonable” is far less persuasive.6 16 11.) 17 (Opposition at The question before the court at this stage is, “When the 18 allegations are accepted as true and taken collectively, would a 19 reasonable person deem the inference of scienter at least as strong 20 as any opposing inference?” Tellabs, 551 U.S. at 326. Viewed as a 21 whole, the totality of the allegations supports fraud. Allegations 22 of tens millions of dollars in cash advances to a small number of 23 shadowy suppliers, a claimed 100% income tax exemption, millions of 24 25 26 27 5 Though it is unclear from the complaint whether Frazer saw or should have seen certain Chinese filings, RINO’s Chinese filings listed $0 in advances at the end of both 2008 and 2009. (TAC ¶¶ 96, 112.) 6 28 Frazer does not directly address the personal loan to RINO’s CEO or the improperly claimed tax credit. 11 1 dollars in unsecured loans to corporate officers, wildly divergent 2 revenue and profit figures, and the inclusion of admittedly 3 uncertain “framework agreements” as revenue provide far more 4 support to the inference that Frazer knowingly or recklessly 5 approved RINO’s fraudulent financial statements than to the 6 competing inferences that RINO’s figures were the result of China’s 7 tax rules, innocent misapplication of accounting methods, or 8 standard business practices. 9 scienter.7 10 11 12 IV. Plaintiff’s has sufficiently alleged Conclusion For the reasons stated above, Frazer Frost’s Motion to Dismiss is DENIED. 13 14 IT IS SO ORDERED. 15 16 17 Dated: August 1, 2013 DEAN D. PREGERSON United States District Judge 18 19 20 21 22 23 24 25 26 27 28 7 Frazer also argues that Plaintiff has failed to demonstrate subjective falsity “for the same reasons that Plaintiff has failed to demonstrate scienter.” (Mot. at 19.) Because Plaintiffs have adequately pled scienter, their subjective falsity allegations also suffice. 12
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