In an opinion issued today, Judge Ramos dismissed securities fraud and related claims brought against Deloitte & Touche for its part in allegedly fraudulent financial statements and other SEC filings by ChinaCast Education, a Chinese company that traded on the NASDAQ from 2006 to 2012. Deloitte was ChinaCast’s auditor, and the plaintiffs were investors in the company, including current management, who claimed to have uncovered misdeeds by ChinaCast’s prior management. Judge Ramos described the plaintiffs’ claims:
At bottom, Plaintiffs contend that, had the Deloitte Defendants performed any audit at all, they would have discovered the rampant fraud at ChinaCast much earlier. The FAC describes a number of failures to comply with PCAOB and GAAP standards, as well as “red flags” that should have placed the Deloitte Defendants on notice of the fraud. Consequently, Plaintiffs assert that DTTC’s statements for the years 2007 through 2010, that it conducted its audits in accordance with PCAOB standards and that ChinaCast’s audited financial statements were GAAP compliant, and for the years 2008 and 2009, that the Company’s internal controls over financial reporting were effective, were materially false.
Judge Ramos, however, held that the complaint failed to state a claim against Deloitte for failing to catch the fraud earlier.
Allegations of a negligent or “shoddy audit” fail to establish fraudulent intent. In re MRU Holdings Sec. Litig., 769 F. Supp. 2d 500, 518 (S.D.N.Y. 2011); In re Puda Coal Sec. Inc., Litig., No. 11 Civ. 2598 (KBF), 2014 WL 2915880, at *13 (S.D.N.Y. Jun. 26, 2014) (“Facts merely supporting an inference that an audit could have been done better constitute ‘fraud by hindsight’ and do not support the requisite scienter.”). Rather, a plaintiff must allege that the auditor employed accounting practices “so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts.” *** Plaintiffs argue that their allegations create an inference of recklessness based on (1) “red flags” and basic accounting failures; (2) the magnitude of the alleged fraud; and (3) the fact that new management quickly discovered the fraud by looking at “the very same records” that DTTC had in its possession. The Second Circuit has held that a “reckless disregard for the truth” signifies “conscious recklessness—i.e., a state of mind approximating actual intent, and not merely a heightened form of negligence.” S. Cherry St., 573 F.3d at 109. Viewed collectively, Plaintiffs’ allegations come close, but ultimately fall short of this especially stringent standard.
Ultimately, Judge Ramos dismissed the plaintiffs’ claims under Sections 10(b), 20(a) and 18 of the Exchange Act, plus their common law fraud claims. However, he did grant the plaintiffs’ motion to amend their complaint, based in part on the plaintiffs’ claim that they continued to identify evidence of the fraud by prior management since taking over the company:
Plaintiffs note that, as a result of the ongoing nature of the ChinaCast investigation, they have incrementally gained access to “documents and evidence looted by prior management.” Pls.’ Opp. DTTC Mot. 2 n.2. In their opposition briefing, Plaintiffs argue that multiple facts absent from the FAC, or not clearly stated therein, would permit the Court to draw stronger inferences of scienter; for example, Plaintiffs claim that, since filing their amended complaint, they have become aware of communications evidencing that “to the extent DTTC reviewed bank statements at all in the course of its audits, it only reviewed the last page and destroyed all others, thereby ignoring” the fraudulent transactions documented therein. Id. Plaintiffs’ opposition brief also notes that DTTC has admitted to the Company’s new management that it failed to test and confirm CCT HK’s bank records and internal controls as required by the Sarbanes Oxley Act for material subsidiaries.