Zech Capital LLC v. Ernst & Young Hua Ming , 636 F. App'x 582 ( 2016 )

15-824-cv
Zech Capital LLC v. Ernst & Young Hua Ming
UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT
SUMMARY ORDER
RULINGS BY SUMMARY ORDER DO NOT HAVE PRECEDENTIAL EFFECT. CITATION TO A
SUMMARY ORDER FILED ON OR AFTER JANUARY 1, 2007, IS PERMITTED AND IS GOVERNED BY
FEDERAL RULE OF APPELLATE PROCEDURE 32.1 AND THIS COURT’S LOCAL RULE 32.1.1.
WHEN CITING A SUMMARY ORDER IN A DOCUMENT FILED WITH THIS COURT, A PARTY MUST
CITE EITHER THE FEDERAL APPENDIX OR AN ELECTRONIC DATABASE (WITH THE NOTATION
“SUMMARY ORDER”). A PARTY CITING A SUMMARY ORDER MUST SERVE A COPY OF IT ON
ANY PARTY NOT REPRESENTED BY COUNSEL.
At a stated term of the United States Court of Appeals for the Second Circuit, held at
the Thurgood Marshall United States Courthouse, 40 Foley Square, in the City of New
York, on the 27th day of January, two thousand sixteen.
PRESENT: RALPH K. WINTER,
REENA RAGGI,
CHRISTOPHER F. DRONEY,
Circuit Judges.
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ZECH CAPITAL LLC,
Plaintiff-Appellant,
BHUSHAN ATHALE, individually and on behalf of all
others similarly situated,
Plaintiff,
JACK CRAYDER, JOHN YOUNG, ROGER
GUSTAFSON, GERMMAINE HEIN-GUSTAFSON, on
behalf of themselves and all others similarly situated,
Consolidated Plaintiffs,
v. No. 15-824-cv
ERNST & YOUNG HUA MING,
Consolidated
Defendant-Appellee,
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SINOTECH ENERGY LIMITED, GOUQIANG XIN,
BOXUN ZHANG, QINGZENG LIU, XIAOXUAN BI,
HEQING YAO, JING LIU, UBS AG, CITIGROUP
GLOBAL MARKETS INC., LAZARD CAPITAL
MARKETS LLC,
Defendants,
GUOQIANG XIN, DONALD J. PUGLISI, UBS
SECURITIES LLC, GRANT THORNTON, AKA JBPB &
Co., GRANT THORNTON HK, AKA JBPB & Co.,
Consolidated Defendants.
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APPEARING FOR APPELLANT: DOUGLAS WILENS, Robbins Geller Rudman
& Dowd LLP, Boca Raton, Florida (Samuel H.
Rudman, David A. Rosenfeld, Christopher M.
Barrett, Robbins Geller Rudman & Dowd LLP,
Melville, New York; Robert B. Weiser, Brett D.
Stecker, Jeffrey J. Ciarlanto, Joseph M. Profy,
The Weiser Law Firm, P.C., Berwyn,
Pennsylvania, on the brief).
APPEARING FOR APPELLEE: RICHARD A. MARTIN (Robert G. Cohen and
Daniel A. Rubens, on the brief), Orrick,
Herrington & Sutcliffe LLP, New York,
New York.
Appeal from a judgment of the United States District Court for the Southern District
of New York (Alison J. Nathan, Judge).
UPON DUE CONSIDERATION, IT IS HEREBY ORDERED, ADJUDGED,
AND DECREED that the judgment entered on February 17, 2015, AFFIRMED.
Plaintiff Zech Capital, LLC (“Zech”) sued defendant Ernst & Young Hua Ming
(“EYHM”) for violations of § 10(b) of the Securities Exchange Act of 1934 (“Exchange
Act”), see 15 U.S.C. §§ 78j(b), 78t(a)–(b), and Securities and Exchange Commission
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(“SEC”) Rule 10b-5, see 17 C.F.R. § 240.10b-5, which plaintiff alleges were committed in
connection with EYHM’s audit of SinoTech Energy Limited (“SinoTech”). Plaintiff now
appeals the dismissal of its third amended complaint (“TAC”) for failure adequately to
allege scienter. See Athale v. SinoTech Energy Ltd., No. 11 Civ. 5831 (AJN) (S.D.N.Y.
Jan. 23, 2015). We review a judgment of dismissal de novo, “accepting all factual
allegations in the complaint as true.” Ellul v. Congregation of Christian Bros., 774 F.3d
791, 796 (2d Cir. 2014). In so doing, we assume the parties’ familiarity with the facts and
the record of prior proceedings, which we reference only as necessary to explain our
decision to affirm.
To survive dismissal, a securities fraud complaint must allege with particularity
both the circumstances constituting fraud and the defendant’s fraudulent intent. See 15
U.S.C. § 78u-4(b); Fed. R. Civ. P. 9(b); Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551
U.S. 308, 313 (2007). To satisfy the latter scienter requirement, a complaint must, “‘with
respect to each act or omission alleged to [constitute securities fraud], state with
particularity facts giving rise to a strong inference that the defendant acted with the
required state of mind.’” ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 99 (2d
Cir. 2007) (quoting 15 U.S.C. § 78u-4(b)(2)). That strong inference must be “cogent and
at least as compelling as any opposing inference one could draw from the facts alleged,”
considered as a whole. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. at 323−24.
The inference may arise from “strong circumstantial evidence of conscious misbehavior or
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recklessness.” ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d at 99. But this does
not equate merely to a heightened form of negligence; rather, the plaintiff must allege “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.”
Rothman v. Gregor, 220 F.3d 81, 90 (2d Cir. 2000) (internal quotation marks and ellipsis
omitted).1
The standard for scienter is especially demanding where, as here, the defendant is an
independent auditor. To state a claim against a non-fiduciary auditor, a plaintiff must
allege with particularity conduct “approximat[ing] an actual intent to aid in the fraud being
perpetrated by the audited company,” In re Advanced Battery Techs., Inc., 781 F.3d 638,
644 (2d Cir. 2015) (internal quotation marks omitted), such as “conduct[ing] an audit so
deficient as to amount to no audit at all, or disregard[ing] signs of fraud so obvious that the
defendant must have been aware of them,” id.
Plaintiff argues that it carried this pleading burden here by alleging that despite
EYHM’s awareness of the weaknesses in SinoTech’s internal controls in auditing
SinoTech’s 2010 Financial Statement, EYHM “failed to employ even the most basic
auditing proceedings” to substantiate SinoTech’s claimed asset valuation, accounts
receivable from two of its subcontractors, or business relationships with its import agent
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The inference can also arise from alleged facts showing that defendant “had both motive
and opportunity to commit the fraud,” ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d
at 99, but plaintiff does not here argue that theory and, thus, we do not discuss it further.
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and chemical supplier. TAC ¶ 100. Plaintiff contends that if EYHM had “conducted any
audit at all, it would have learned, in very short order (if it did not already know) that a high
percentage of SinoTech’s assets and revenues reported in the 2010 Financial Statements
were completely fictitious.” Id. ¶ 102.
Insofar as plaintiff thus charges EYHM with violating generally accepted
accounting principles (“GAAP”) or generally accepted auditing standards (“GAAS”), this
court has already concluded that “allegations of GAAP violations or accounting
irregularities, standing alone, are insufficient to state a securities fraud claim.” Novak v.
Kasaks, 216 F.3d 300, 309 (2d Cir. 2000). Such allegations must be “coupled with
evidence of corresponding fraudulent intent” to admit a strong inference of scienter. Id.
(internal quotation marks omitted). To the extent disregarded “red flags” can satisfy that
requirement, see Stephenson v. PricewaterhouseCoopers, LLP, 768 F. Supp. 2d 562, 573
(S.D.N.Y. 2011) (“Allegations of ‘red flags,’ when coupled with allegations of GAAP and
GAAS violations, are sufficient to support a strong inference of scienter.” (internal
quotation marks and alteration omitted)), aff’d, 482 F. App’x 618 (2d Cir. 2012) (summary
order); see also In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 279–81 (3d Cir.
2006) (concluding that plaintiff adequately raised strong inference of scienter by alleging
GAAS violations and thirty indicators of fraud ignored in audit), Zech points to no such
“red flags” here. While it alleges EYHM’s knowledge of “material weaknesses” in
SinoTech’s internal controls, Zech does not explain with particularity how that “would
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place a reasonable auditor on notice that the audited company was engaged in wrongdoing
to the detriment of its investors,” Stephenson v. PricewaterhouseCoopers, LLP, 768 F.
Supp. 2d at 573; see In re Advanced Battery Techs., Inc., 781 F.3d at 645−46, or how
EYHM’s failure to modify its auditing practices in light of SinoTech’s weaknesses was
highly unreasonable conduct that went beyond negligence.
Nowhere does Zech allege that, in conducting its audit, EYHM ignored “obvious
signs of fraud” or “failed to review or check information that [it] had a duty to monitor.”
Novak v. Kasaks, 216 F.3d at 308. And, apart from noting the size of particular valuations
and claimed account receivables, plaintiff alleges no facts indicating EYHM’s awareness
that any particular transaction was suspicious, such that its failure to investigate effectively
turned a blind eye to fraud. See Chill v. General Elec. Co., 101 F.3d 263, 270 (2d Cir.
1996) (“The fact that [defendant] did not automatically equate record profits with
misconduct cannot be said to be reckless.”); see also Iowa Pub. Emp.’s Ret. Sys. v. Deloitte
& Touche LLP, 919 F. Supp. 2d 321, 332 (S.D.N.Y. 2013) (concluding that if auditor is not
aware of facts indicating that transaction was suspicious or fraudulent, auditor’s failure to
investigate, “even if negligent,” does not provide basis for fraud claim).
Plaintiff’s emphasis on the scope and significance of EYHM’s deviations from
standard accounting practices warrants no different conclusion because, in the end, its
argument is that (1) if EYHM had conducted its audit according to accepted practices, it
would have uncovered SinoTech’s fraud; (2) EYHM did not uncover the fraud; thus, (3)
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EYHM’s audit was not sufficient. The issue, however, is not the sufficiency of EYHM’s
audit, but its intent in conducting the audit. Zech’s pleadings fail to allege facts admitting
a strong inference that EYHM’s particular auditing procedures were reckless and not
merely highly negligent. See In re Advanced Battery Techs., Inc., 781 F.3d at 646. This
court has rejected similar attempts to establish scienter through hindsight evaluations of a
defendant’s conduct. See Novak v. Kasaks, 216 F.3d at 309 (explaining “important
limitations” on liability for reckless conduct, including prohibition against allegations of
“fraud by hindsight”); Stevelman v. Alias Research Inc., 174 F.3d 79, 85 (2d Cir. 1999)
(rejecting as “fraud by hindsight” argument that “[m]anagement’s optimism that is shown
only after the fact to have been unwarranted” can be strong circumstantial evidence of
recklessness); Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978) (affirming dismissal of
complaint because it merely alleged “fraud by hindsight” and nowhere alleged “with the
required particularity” that, when defendants issued statement, they had “perceptions or
were reckless in not having [perceptions]” about specific transactions). The pleadings
here warrant no different outcome.
That conclusion is reinforced by the “inherently comparative” nature of the scienter
inquiry here, which does not require a court to draw all inferences in plaintiff’s favor. See
Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. at 323. Rather, we must “take into
account plausible opposing inferences” and consider “nonculpable explanations for the
defendant’s conduct, as well as inferences favoring the plaintiff.” Id. at 323−24. When
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all permissible inferences are considered here, Zech’s theory of recklessness is less
compelling than the opposing logical inference of EYHM’s negligence.
In sum, we conclude, as the district court did, that the circumstantial evidence
alleged in the TAC, taken collectively, does not admit a strong inference that EYHM was
complicit in SinoTech’s fraud or that it recklessly conducted its audit so as to admit an
inference that it knew or must have been aware of the fraud. See Rothman v. Gregor, 220
F.3d at 90. Accordingly, the TAC was correctly dismissed for failure adequately to plead
scienter.
We have considered plaintiff’s remaining arguments and conclude that they are
without merit. We therefore AFFIRM the judgment of the district court.
FOR THE COURT:
CATHERINE O’HAGAN WOLFE, Clerk of Court
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