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Miller Investment Trust v. Morgan Stanley & Co. LLC

United States District Court, D. Massachusetts

March 30, 2018

MILLER INVESTMENT TRUST and JURA LIMITED, Plaintiffs,
v.
MORGAN STANLEY & CO., LLC and KPMG HONG KONG, Defendants.

          MEMORANDUM AND ORDER

          DOUGLAS P. WOODLOCK UNITED STATES DISTRICT JUDGE

         TABLE OF CONTENTS

         I. FACTUAL BACKGROUND .......................................... 4

         A. Shengda's Note Offering and the Plaintiffs' Purchases .... 4

         B. KPMG-HK's Realization of Shengda's Overvaluation and ......Shengda's Bankruptcy ......................................... 6

         C. Alleged Misrepresentations by KPMG-HK .................... 9

         D. Impact of Misrepresentations on the Plaintiffs .......... 11

         II. PROCEDURAL HISTORY ........................................ 12

         III. STANDARD OF REVIEW ....................................... 18

         IV. DISCUSSION ................................................ 20

         A. Section 18 Claim ........................................ 20

         1. Pleading Requirements ................................. 20

         2. False or Misleading Statements ........................ 23

         a. Conformance of KPMG-HK's Audit of Shengda's Financial . Statements and Internal Controls with PCAOB Standards .... 29

         i. Failure to Investigate False Statements About SSCM by .Shengda's CFO ....................................... 33

         ii. Internal Control Deficiencies ...................... 43

         iii. Failure to Establish Direct Contact in the .........Confirmation Process .................................... 46

         iv. Ignoring Red Flags ................................. 51

         v. Alleged Violations After March 2010 ................. 55

         vi. Import of the Magnitude of the Fraud and the East of .its Discovery ...................................... 57

         b. Conformance of Shengda's Financial Statements with .....GAAP ................................................ 59

         c. Loss Causation ...................................... 66

         B. Negligent Misrepresentation Claim ....................... 77

         1. Pleading Requirements ................................. 77

         2. False Information ..................................... 80

         3. Justifiable Reliance .................................. 83

         IV. CONCLUSION ................................................ 88

         Plaintiffs 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 bonds.

         The 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.

         I. FACTUAL BACKGROUND

         I recount the facts as alleged in the Third Amended Complaint as true, focusing primarily on those allegations pertaining to KPMG-HK.

         A. Shengda's Note Offering and the Plaintiffs' Purchases

         Shengda 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.[1] Id. ¶¶ 34, 38.

         In 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, [2] 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[3] 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.

         After 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, [4] 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.

         B. KPMG-HK's Realization of Shengda's Overvaluation and Shengda's Bankruptcy

         In 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. ¶ 227.

         Beginning 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. ¶ 231.

         In 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.

         On May 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.

         On June 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.

         On 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.[5] 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. ¶¶ 252-254.

         C. Alleged Misrepresentations by KPMG-HK

         The 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.

         Specifically, the Plaintiffs assert that KPMG-HK made two materialy false statements:

         First, regarding its own compliance with Public Company Accounting Oversight Board (“PCAOB”) standards in auditing Shengda's financial statements; and

         Second, 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.

         KPMG-HK's 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.[6] 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 PPM.[7] TAC ¶ 34.

         In 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.

         D. Impact of Misrepresentations on the Plaintiffs

         The 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.

         The 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.

         II. PROCEDURAL HISTORY

         This 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.

         Miller 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. Mass. 2012).[8]

         KPMG-HK 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).[9] 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.

         Miller 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.[10]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.

         Thereafter, 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 thereafter.

         The Plaintiffs filed their Second Amended Complaint on March 10, 2014.[11] 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.[12] 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 pending.

         On 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.

         The 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.

         III. STANDARD OF REVIEW

         In 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).

         The 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 parties.[13]

         IV. DISCUSSION

         A. Section 18 Claim

         1. Pleading Requirements

         Federal 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).

         Since 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).[14] 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).

         To make 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.

         Miller 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.[15] 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.[16]

         2. False or Misleading Statements

         What is 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).[17]

         In Omnicare, the Supreme ...


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