United States District Court, D. Massachusetts
MEMORANDUM AND ORDER
DOUGLAS P. WOODLOCK UNITED STATES DISTRICT JUDGE
FACTUAL BACKGROUND ..........................................
Shengda's Note Offering and the Plaintiffs'
Purchases .... 4
KPMG-HK's Realization of Shengda's Overvaluation and
Alleged Misrepresentations by KPMG-HK
Impact of Misrepresentations on the Plaintiffs
PROCEDURAL HISTORY ........................................
STANDARD OF REVIEW ....................................... 18
Section 18 Claim
Pleading Requirements ................................. 20
False or Misleading Statements ........................ 23
Conformance of KPMG-HK's Audit of Shengda's Financial
. Statements and Internal Controls with PCAOB Standards ....
Failure to Investigate False Statements About SSCM by
.Shengda's CFO ....................................... 33
Internal Control Deficiencies ...................... 43
Failure to Establish Direct Contact in the
Ignoring Red Flags ................................. 51
Alleged Violations After March 2010 ................. 55
Import of the Magnitude of the Fraud and the East of .its
Discovery ...................................... 57
Conformance of Shengda's Financial Statements with
.....GAAP ................................................ 59
Causation ...................................... 66
Negligent Misrepresentation Claim
Pleading Requirements ................................. 77
False Information ..................................... 80
Justifiable Reliance .................................. 83
Miller Investment Trust (“Miller”) and Jura
Limited (“Jura”) seek to recover investment
losses from purchases of $8.7 million of bonds offered by
ShengdaTech, Inc. (“Shengda”) made between
December 2010 and February 2011. In March 2011, it was
reported that Shengda had vastly overstated its revenues.
Shortly thereafter, Shengda defaulted and declared
bankruptcy. In December 2011, Miller brought this action
alleging securities fraud against Defendants Morgan Stanley,
which underwrote the offering, and KPMG Hong Kong
(“KPMG-HK”), Shengda's auditor. The
Plaintiffs allege that Morgan Stanley and KPMG-HK knew or
should have known about misrepresentations of material fact
made in the offering documents provided to the Plaintiffs on
which Plaintiffs relied in deciding to purchase the Shengda
instant motion to dismiss pertains only to those claims
asserted by Miller against KPMG-HK. Following several
iterations of the complaint, after each of which KPMG-HK has
moved to dismiss, now before me is KPMG-HK's motion for
dismissal of the two counts against it set forth in the Third
Amended Complaint: negligent misrepresentation under state
common law and violation of § 18 of the Securities
Exchange Act of 1934, 15 U.S.C. § 78r.
recount the facts as alleged in the Third Amended Complaint
as true, focusing primarily on those allegations pertaining
Shengda's Note Offering and the Plaintiffs'
was a Nevada corporation with its principal place of business
in the People's Republic of China. Third Am. Compl. (TAC)
¶ 37. Before its bankruptcy, Shengda primarily
manufactured a chemical additive called nano-precipitated
calcium carbonate, which is used to improve industrial
materials such as paint, paper, plastic, and rubber.
Id. It conducted its manufacturing operations
through Chinese subsidiaries. Id. ¶¶ 34, 38.
2010, Shengda sold an aggregate of $130 million of 6.5%
senior convertible notes due in 2015 through a private
placement offering closing in December 2010. TAC ¶¶
1, 16, 219, 224. In connection with the offering, Morgan
Stanley,  the underwriter, prepared a private
placement memorandum (“PPM”) that would be
distributed to potential purchasers. Id.
¶¶ 2, 20, 23, 32, 33, 258. The PPM contained
numerous financial documents relating to Shengda, including
its 2008 and 2009 SEC Form 10-Ks, each of which contained an
audit report from KPMG-HK for the respective fiscal years
2008 and 2009. Id. ¶¶ 2, 34, 258. Shengda
retained KPMG-HK to serve as its independent auditor from
November 2008 until April 2011, during which time KPMG-HK
completed audits for fiscal years 2008 and 2009, and
partially completed an audit for 2010. Id.
¶¶ 34, 58.
receiving additional assurances from KPMG-HK as to the use of
its audit reports and the accuracy of Shengda's financial
statements, Morgan Stanley distributed the PPM to potential
buyers, including Wellesley Investment Advisors, Inc. TAC
¶¶ 2, 23, 34, 220, 243, 258. Wellesley Investment
Advisors is a registered investment adviser in Massachusetts
that manages Miller, a mutual fund, and has full investment
authority over the funds of Jura, a Bermuda corporation.
Id. ¶¶ 28, 30-31. Relying on the
information provided in the PPM and in Shengda's SEC
filings, Miller purchased approximately $8 million of Shengda
bonds (Shengda's 2015 Notes) between December 10, 2010
and February 16, 2011,  id. ¶¶ 20-21, 29,
32, 243-244, from Morgan Stanley, through the private
placement and four subsequent transactions. Jura, through
Wellesley Investment Advisors, purchased $700, 000 of Shengda
convertible bonds in two purchases on December 12, 2010 and
February 27, 2011. Id. ¶¶ 30-32, 243-245.
KPMG-HK's Realization of Shengda's Overvaluation and
conducting its audit for Shengda for fiscal year 2010,
KPMG-HK conducted additional procedures that it had allegedly
assured the chair of Shengda's Audit Committee it would
perform. TAC ¶¶ 17, 166. On March 1 and 2, 2011,
KPMG-HK began contacting Shengda's customers, suppliers,
and banks using publicly available contact information, and
learned that many of Shengda's claims regarding business
relationships and financial statements were false.
Id. ¶¶ 17, 225-226. Specifically, KPMG-HK
“could not confirm sales amounts, sales terms, and
outstanding balances, discovered that many documents
ShengdaTech provided to KPMG were crude forgeries, discovered
that certain transactions had been with related parties
without necessary disclosure, and that suppliers and
customers denied engaging in business with
ShengdaTech.” Id. ¶ 226. The Plaintiffs
contend that KPMG-HK would have discovered these issues
earlier had it $410, 000 on February 4, 2011; $1, 000, 000 on
February 11, 2011; and $1, 000, 000 on February 16, 2011.
Id. ¶ 244. conducted its 2008 and 2009 audits
consistent with governing auditing standards. Id.
on March 2, 2011, and through a series of three memoranda
thereafter, KPMG-HK informed Shengda's Audit Committee of
its discovery of “potentially serious discrepancies and
unexplained issues” during its audit of Shengda's
financial statements for fiscal year 2010. TAC ¶¶
226-227. Shengda immediately convened a special committee,
composed of the independent directors on the Audit Committee
and advised by a law firm and an accounting firm, to conduct
an internal investigation. Id. ¶¶ 228-229.
On March 14, NASDAQ suspended trading in Shengda's equity
securities, thereafter stating that it would not resume
trading until Shengda had “fully satisfied NASDAQ's
request for additional information.” Id.
¶¶ 230, 232. The next day, Shengda issued a press
release announcing the appointment of the special committee
“to investigate potentially serious discrepancies and
unexplained issues relating to the Company and its
subsidiaries' financial records.” Id.
April 2011, KPMG-HK resigned as Shengda's auditor,
stating that it had “doubts about management's
representations provided to [KPMG-HK] in connection with
[its] 2008 and 2009 audits of the consolidated financial
statements and the effectiveness of internal control over
financial reporting of the Company.” TAC ¶ 233.
KPMG-HK implored Shengda to make disclosures regarding any
errors in previously issued audit reports to prevent future
reliance on them. Id.
5, Shengda filed a current report on Form 8-K with the SEC,
stating that “KPMG previously informed the
Company's Audit Committee of certain concerns arising
during its incomplete audits of the Company's
consolidated financial statements as of and for the year
ended December 31, 2010, and the effectiveness of internal
control over financial reporting as of December 31,
2010.” TAC ¶ 234. It went on to identify issues
related to bank balances, supplier transactions, VAT tax
invoices, third-party sales and payments, customer sales, and
the confirmation process. Id.
9, Shengda announced that it was in default on the
convertible bond securities issued in the 2010 private
placement; the next day, all trading of Shengda stock was
suspended by NASDAQ. TAC ¶¶ 235-236. The SEC
thereafter commenced a regulatory proceeding resulting in an
order noting potential federal securities laws violations
arising from false statements made in the 2009 Form 10-K, the
2009 Form 10-K/A, and the 2009 and 2010 Form 10-Qs.
Id. ¶¶ 237, 239.
August 19, Shengda filed a Chapter 11 bankruptcy petition and
an adversary proceeding against its Chief Executive Officer,
Ziangzhi Chen, to prevent him from interfering with the
restructuring. TAC ¶¶ 238, 240-241, 251.
See In re ShengdaTech, Inc., BK-11-52649 (D. Nev.
Aug. 19, 2011, ECF No. 1); see also ShengdaTech, Inc. v.
Chen, 11-05082-BTB (D. Nev. Aug. 23, 2011, ECF No. 12).
With this filing, the Plaintiffs' notes became
immediately due and payable by their terms. Id.
¶ 238. In bankruptcy, Shengda has been unable to satisfy
the vast majority of its liabilities. Id.
Alleged Misrepresentations by KPMG-HK
Plaintiffs allege that the offering documents in the PPM on
which they relied in purchasing the Shengda bonds contained
material misrepresentations that made Shengda appear far more
stable financially than it was. TAC ¶¶ 22, 26, 32,
61, 62. Further, they contend that KPMG-HK, as Shengda's
auditor (and Morgan Stanley as Shengda's underwriter),
“had access to ShengdaTech's internal reports and
other data and information about those companies'
finances, operations and sales at all relevant times, ”
and failed to perform its auditing responsibilities
adequately, such that it would have discovered Shengda's
fraud, in light of this information. Id.
¶¶ 6, 246.
the Plaintiffs assert that KPMG-HK made two materialy false
regarding its own compliance with Public Company Accounting
Oversight Board (“PCAOB”) standards in auditing
Shengda's financial statements; and
regarding Shengda's compliance with generally accepted
accounting principles (“GAAP”) in preparing its
financial statements. The Plaintiffs contend that KPMG-HK
knew or should have known that these statements were false.
TAC ¶¶ 59-61.
statement of PCAOB compliance appears in its audit reports
for fiscal years 2008 and 2009, dated March 31, 2009 and
March 15, 2010, respectively, and in its internal control
audit report for fiscal year 2008, also dated March 31, 2009.
TAC ¶¶ 34, 59-61; 2008 Audit Report; 2009 Audit
Report; 2008 Internal Control Audit Report. KPMG-HK's
statement of GAAP compliance also appears in its audit
reports for fiscal years 2008 and 2009. TAC ¶¶
59-60; 2008 Audit Report; 2009 Audit Report. These audit
reports were incorporated into Shengda's 2008 Form 10-K,
filed April 1, 2009, and Shengda's 2009 Form 10-K, filed
March 15, 2010, respectively, and were included in the
TAC ¶ 34.
addition, the Plaintiffs identify an allegedly false or
misleading statement in a comfort letter KPMG-HK provided to
Morgan Stanley in connection with the private placement,
dated December 9, 2010. TAC ¶¶ 34, 220. In that
letter, KPMG-HK consented to the use of its audit reports and
its review of Shengda's 2010 quarterly financial
statements in the PPM and acknowledged that purchasers would
rely on the opinions expressed therein. Id.
¶¶ 34, 220. KPMG-HK also affirmed its opinion as to
the accuracy of Shengda's 2010 quarterly financial
statements, noting that KPMG-HK did not believe that
“any material modifications should be made to the
unaudited condensed consolidated financial statements”
included in the PPM “for them to be in conformity with
U.S. generally accepted accounting principles.”
Id. ¶¶ 221(a), 272.
Impact of Misrepresentations on the Plaintiffs
Plaintiffs allege that they relied to their detriment on the
misrepresentations and omissions of KPMG-HK and Morgan
Stanley in the documents that led the Plaintiffs to purchase
the Shengda notes. TAC ¶¶ 20-22, 26, 32. According
to the Plaintiffs, the materially false or misleading
statements created “an unrealistically positive
assessment of ShengdaTech” in the market, and this
“fraudulently created” both a market for and an
overvaluing of the notes. Id. ¶¶ 22, 26,
32, 61-62, 247. They contend that the notes “would
never have come into the market but for the fraud, ”
or, if they had, would have done so with more favorable terms
to investors, and that the Plaintiffs would not have
purchased the notes at all or on the terms they did but for
the misrepresentations of KPMG-HK and Morgan Stanley.
Id. ¶ 247.
Plaintiffs further allege that immediately following
Shengda's March 2011 press release stating that KPMG-HK
had encountered discrepancies in its 2010 audit, the
Plaintiffs sought to sell their convertible bonds, but the
market had become illiquid. Id. ¶¶
248-250. As a result, having purchased the bonds at or near
par, and in many cases above par value, the Plaintiffs
“lost nearly their entire investment.”
Id. ¶¶ 25, 231, 248-250, 255.
case came to this session, having been before two other
judges in this district previously. The motion to dismiss now
before me follows a familiar pattern for motion to dismiss
practice in securities fraud litigation: successive motions
to amend the pleadings creating a moving target for an
extended period of time until the plaintiffs' allegations
come to rest and can be examined by the court.
filed its complaint on December 1, 2011, alleging one count
of violation of the Massachusetts Uniform Securities Act,
Mass. Gen. Laws. ch. 110A, § 410, against Morgan Stanley
and one count of negligent misrepresentation under state
common law against KPMG-HK. Compl. ¶¶ 1-3, 143-157.
Morgan Stanley filed a motion to dismiss the original
complaint on January 31, 2012 for failure to state a claim.
This was denied by Judge Tauro. See Miller Inv. Trust v.
Morgan Stanley & Co. Inc., 879 F.Supp.2d 158 (D.
filed its first motion to dismiss on June 7, 2012, asserting
insufficient service and failure to state a claim of
negligent misrepresentation under Fed.R.Civ.P. 8(a) or
Fed.R.Civ.P. 9(b). Before ruling on the motion to dismiss,
and at the joint request of Miller and KPMG-HK, Judge Tauro
granted Miller leave to file an Amended Complaint to add a
claim against KPMG-HK arising under § 18 of the
Securities Exchange Act of 1934, 15 U.S.C. § 78r (the
“Exchange Act”). The earlier motion to dismiss
was treated as superseded and KPMG-HK was given the
opportunity to file a new motion to dismiss.
filed its first Amended Complaint on August 29, 2012,
preserving the original two counts and adding a third count
for violation of § 18 of the Exchange Act by
KPMG-HK.KPMG-HK thereafter filed a motion to
dismiss for insufficient service and inadequate pleading of
both the § 18 claim and the negligent misrepresentation
claim. Judge Tauro provided Miller with the opportunity to
re-serve KPMG-HK in compliance with the Hague Convention, in
order to remedy the insufficient service of KPMG-HK, and
denied KPMG-HK's motion to dismiss as moot.
in July 2013, KPMG-HK filed a renewed motion to dismiss the
Amended Complaint asserting inadequacy in the pleadings.
Miller moved for leave to file a Second Amended Complaint,
having provided notice of its intent to do so in November
2013 in light of factual discovery it was obtaining in
another matter regarding the same underlying events.
Simultaneously, Jura moved to intervene as a plaintiff
pursuant to Fed.R.Civ.P. 24(b)(2) with respect to only count
one against Morgan Stanley. Judge O'Toole granted both
the motion for leave to amend and the motion to intervene,
and dismissed KPMG-HK's pending motion to dismiss as moot
in light of the anticipated Second Amended Complaint,
permitting KPMG-HK to file a new motion to dismiss
Plaintiffs filed their Second Amended Complaint on March 10,
2014. That complaint preserved the three
counts in the Amended Complaint and added Jura as a claimant
in count one only. Second Am. Compl. ¶¶ 245-265. In
addition, the reorganized Second Amended Complaint added
fifty pages of new allegations, derived largely from
discovery in an action pursued by the Plaintiffs against
Shengda's directors and officers in the Southern District
of New York and from a complaint filed by Shengda's
liquidating trustee. Morgan Stanley dutifully filed an answer
to the Second Amended Complaint, and KPMG-HK filed a motion
to dismiss, again alleging failure to plead adequately both
the § 18 claim and the negligent misrepresentation
claim. Following further briefing, the case was reassigned to
this session with KPMG-HK's motion to dismiss still
January 15, 2015, the Plaintiffs filed yet another motion to
amend the complaint and for leave to file additional
allegations, which KPMG-HK opposed. After argument on both, I
granted Miller's motion to amend and denied KPMG-HK's
motion to dismiss without prejudice. Thereafter, Miller filed
its Third Amended Complaint. Morgan Stanley again answered
the complaint, and KPMG-HK filed the motion to dismiss both
counts against it for inadequate pleadings now before me.
claims relevant to the instant motion - those brought by
Miller against KPMG-HK - are that the statements in the 2008
and 2009 audit reports, regarding KPMG-HK's compliance
with the PCAOB standards and Shengda's compliance with
GAAP, constitute negligent misrepresentation and violate
§ 18 of the Exchange Act, and further that the statement
in KPMG-HK's comfort letter that Shengda's 2010
quarterly financial statements conformed with GAAP also
constitutes negligent misrepresentation. TAC ¶¶
268, 272, 277, 278.
STANDARD OF REVIEW
order to survive a motion to dismiss pursuant to Fed.R.Civ.P.
12(b)(6), “a complaint must contain sufficient factual
matter, accepted as true, to state a claim to relief that is
plausible on its face.” Ashcroft v. Iqbal, 556
U.S. 662, 678 (2009) (internal quotation marks and citation
omitted). Dismissal for failure to state a claim is
appropriate when the pleadings set forth nothing more than
“[t]hreadbare recitals of the elements of a cause of
action, supported by mere conclusory statements.”
Id.; see Maldonado v. Fontanes, 568 F.3d
263, 268 (1st Cir. 2009); see also Menard v. CSX Transp.,
Inc., 698 F.3d 40, 45 (1st Cir. 2012).
controlling pleading is the Plaintiffs' Third Amended
Complaint. Although I am “generally limited to
considering facts and documents that are part of or
incorporated into the complaint, ” Giragosian v.
Ryan, 547 F.3d 59, 65 (1st Cir. 2008) (citation and
internal quotation marks omitted), I may also consider
documents to which “a complaint's factual
allegations are expressly linked.” Beddall v. State
St. Bank & Trust Co., 137 F.3d 12, 17 (1st Cir.
1998); see In re Citigroup, Inc., 535 F.3d 45, 52
(1st Cir. 2008). Here, I will consider the audit reports
prepared by KPMG-HK for fiscal years 2008 and 2009, including
the 2008 internal control audit report; the comfort letter
issued by KPMG-HK in December 2010; the 2011 press releases,
which have been provided by the Plaintiff; and relevant SEC
filings to the extent they have been incorporated into the
Third Amended Complaint and provided by the
Section 18 Claim
Rule of Civil Procedure 8(a)(2) requires that a complaint
provide “a short and plain statement of the claim
showing that the pleader is entitled to relief.” Claims
under § 18 of the Exchange Act are subject to the
heightened “clarity and basis” pleading
requirement of the Private Securities Litigation Reform Act
of 1995 (“PSLRA”), 15 U.S.C. § 78u-4.
See generally In re Stone & Webster, Inc., Sec.
Litig., 414 F.3d 187, 195, (1st. Cir. 2005) (“The
clarity-and-basis requirement of the PSLRA . . . seem to
apply equally to claims under . . . § 18.”). Under
this requirement, plaintiffs must “specify each
statement alleged to have been misleading, the reason or
reasons why the statement is misleading, and, if an
allegation regarding the statement or omission is made on
information and belief, the complaint shall state with
particularity all facts on which that belief is
formed.” 15 U.S.C. § 78u-4(b)(1)(B); see In re
Stone & Webster, Inc., 414 F.3d at 194-95, 199.
Where the allegations are made on the basis of information
and belief, plaintiffs must specifically identify the sources
used in investigating the claims that form the basis for
their allegations. See Special Situations Fund
III, L.P. v. Am. Dental Partners, Inc., 775 F.Supp.2d
227, 238-39 (D. Mass. 2011).
the passage of the PSLRA, the First Circuit has observed that
the PSLRA pleading standards are “congruent and
consistent” with its own prior interpretation of
Federal Rule of Civil Procedure 9(b), and that both
essentially impose the same requirements. Greebel v. FTP
Software, Inc., 194 F.3d 185, 193-94 (1st Cir. 1999);
see In re Stone & Webster, Inc., 414 F.3d at
195, 199. Consistent with Greebel, other judges in
this district have concluded that Rule 9(b) applies to §
18 claims. See Lindner Dividend Fund, Inc. v. Ernst &
Young, 880 F.Supp. 49, 57 (D. Mass. 1995) (collecting
cases and finding Rule 9(b) applicable to § 18
claims). Accordingly, I hold that Miller's
§ 18 claim must satisfy the pleading standards of both
the PSLRA and Rule 9(b), which requires Miller to
“state with particularity the circumstances
constituting fraud or mistake.” See McGinty v.
Beranger Volkswagen, Inc., 633 F.2d 226, 228 (1st Cir.
1980) (Rule 9(b) requires “specification of the time,
place, and content of an alleged false
representation”), superseded in part by the
PSLRA, Pub. L. No. 104-67, 109 Stat. 737 (1995).
a claim under § 18(a), Miller must plead that “(i)
the defendant made a [materially] false or misleading
statement, (ii) the statement was contained in a document
‘filed' pursuant to the Exchange Act or any rule or
regulation thereunder, (iii) reliance on the false statement,
and (iv) resulting loss to [Miller].” In re Stone
& Webster, Inc., 414 F.3d at 193; see 15
U.S.C. § 78r; Special Situations Fund, 775
F.Supp.2d at 245. Proof of scienter is not required. In
re Stone & Webster, Inc., 414 F.3d at 193, 202.
has identified three specific SEC filings in which it
contends that KPMG-HK made false statements: (a) the 2008
audit report accompanying Shengda's 2008 Form 10-K, (b)
the 2008 internal control audit report accompanying
Shengda's 2008 Form 10-K, and (c) the 2009 audit report
accompanying Shengda's 2009 Form 10-K. These filings
were included in the PPM on which the Plaintiffs relied in
deciding to purchase the Shengda bonds in 2010. KPMG-HK
asserts that Miller has failed to satisfy elements (i) that
any statements therein were false or misleading, and (iv)
that Miller's loss was caused by KPMG-HK's false
representations for each of these documents.
False or Misleading Statements
required to plead and prove falsity under federal securities
laws depends on whether the statement at issue is one of fact
or opinion. The Supreme Court clarified the distinction
between these types of statements and when they may be
actionable for their falsity in Omnicare, Inc. v.
Laborers District Council Construction Industry
Pension Fund, 135 S.Ct.1318 (2015).
Omnicare, the Supreme ...