Sun v. Han, 2015 U.S. Dist. LEXIS 170005 (D.N.J. Dec. 21, 2015):

This matter comes before the Court by way of Defendant Mazars CPA Limited ("Mazars CPA" or "Defendant")'s Motion to Dismiss (ECF No. 30, "Def s. Mov. Br.") Plaintiff Bin Qu's amended putative class action complaint ("Amended Complaint") (ECF No. 28, "Compl."). Mazars CPA seeks dismissal for failure to state a claim upon which relief can be granted pursuant to Federal Rules of Civil Procedure 9(b) and 12(b)(6) and pursuant to the heighted pleading requirements of the Private Securities Litigation Reform Act ("PSLRA"). Plaintiff has opposed this Motion, and Mazars CPA has replied [*2]  to that opposition. (ECF Nos. 38, "P1's. Opp. Br." and 41, "Def s. Reply Br."). This Court has considered the Parties' submissions and rules on this motion without oral argument pursuant to Federal Rule of Civil Procedure 78. For the reasons set forth below, the Court denies Mazars CPA's Motion to Dismiss.

BACKGROUND

Lead Plaintiff Bin Qu brings this action individually and on behalf of a proposed class of investors who acquired securities of Telestone Technologies Corporation ("Telestone" or "the Company") between March 31, 2010 and April 16, 2013. (Compl. ¶ 1). The class seeks remedies pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. (Id.). Plaintiff alleges securities violations against Telestone, Telestone's individual officers, and against Telestone's outside [*3]  auditor (the instant Moving Defendant, Mazars CPA), as well as against the allegedly related entities of Mazars Scrl and WeiserMazars LLP. (Id. ¶¶ 20-34). Plaintiff's original complaint was filed on February 2, 2015, and the operative amended complaint ("Complaint") was filed on August 17, 2015. (ECF Nos. 1, 28).

Telestone provides wireless local-access network technologies and solutions primarily in the People's Republic of China. (Compl. ¶ 2). As the Amended Complaint explains, the Company gained access to the United States market through a process known as a "reverse merger or reverse take-over ("RTO")" with a United States company that had previously declared bankruptcy. (Id. ¶ 41). A Wall Street Journal Article cited by Plaintiff explains the RTO in this way:

   In reverse mergers, a foreign company is 'bought' by a publicly traded U.S. shell company. But the foreign company assumes control and gets the shell's U.S. listing without the level of scrutiny that an initial public offering entails. Though companies from other countries also engage in [*4]  reverse mergers, such deals are especially common among the Chinese. The Public Company Accounting Oversight Board ("PCAOB")] says nearly three-quarters of the 215 Chinese companies listing in the U.S. from 2007 to early 2010 did so via reverse merger.

(Id. ¶ 43, quoting Michael Rappaport, SEC Probes China Auditors, WALL STREET JOURNAL (June 3, 2011)). Thus, Plaintiff alleges that by entering the United States market by way of an RTO, "Telestone was able to avoid substantial regulatory scrutiny and disclosure required in [a traditional initial public offering]." (Id. ¶¶ 40-47). According to Plaintiff, by proceeding through "backdoor registration" into the marketplace, there is a greater likelihood that a company will "have significant accounting deficiencies or [act as] vessels of outright fraud." (Id. ¶ 46, quoting an April 4, 2011 speech by former SEC Commissioner Luis A. Aguilar).

Against this backdrop, Plaintiff explains that the telecommunications industry in China, in which Telestone is a participant, "is dominated by three state-run businesses," known as "the Big ," who award their contracts through competitive bidding. (Id. ¶ 4). The vast majority of Telestone's revenues--upwards [*5]  of 95 percent--come from business with the Big 3. (Id. ¶ 4). According to the Amended Complaint, there are significant risks to doing business with Government-run companies. (Id. ¶¶ 4-10). For example, Telestone's communications with the SEC acknowledged that: "the carriers have their own payment process which is always not in accordance with the terms as stipulated in contracts," which "is why [Telestone's days sales outstanding (^DS0') has continued to increase," that; "[b]ecause of the absolute monopoly position of the Big 3 carriers . . . [the Company is] unable to exercise significant influence to ask the Big 3 carriers to follow the terms as stipulated in our contracts,"; and that the Big 3 have a "practice of delaying payments." (Id. ¶¶ 49-60).

During the class period, the SEC investigated Telestone's financial reporting practices. (Id. 1-1-49-60). Specifically, through a series of communications, the SEC expressed its concern over the fact that Telestone appeared to be recognizing revenue on business done with the Big 3, despite Telestone's own representations as to the tenuousness of doing business with these Government-run companies. (Id. ¶¶ 49-60). The SEC also expressed concern over [*6]  the lengthening of Telestone's accounts receivable turnover period from 690 days at the end of December 2011 to a "period of 1,232 days for the three months ended June 30, 2012," which the SEC viewed as "indicative of deterioration in [Telestone's] customer's credit or ability/willingness to pay." (Id. ¶¶ 50, 57). These SEC communications were made public in February 2014. (Id. ¶ 60).

Ultimately, on September 4, 2013, after its investigation into the Company's accounting and reporting practices, the SEC required that Telestone "file a Current Report on a Form 8-K announcing that certain previously issued financial statements should no longer be relied on and to amend certain financial statements." (Id. ¶¶ 2, 59). Telestone was removed from the United States marketplace on April 17, 2013, when, according to Plaintiff, "the Company disclosed that it was not able to file its annual report since it was unable to obtain the financial records from one of its subsidiaries." (Id. ¶ 14).

The gravaman of Plaintiffs Amended Complaint is that [*7]  Telestone misrepresented that its financial statements were presented in accordance with Generally Accepted Accounting Principles ("GAAP")⁴ and that, contrary to GAAP, it recognized revenue where the collectability of that revenue was not reasonably assured. Specifically, Plaintiff alleges that

   Telestone's business practice throughout the Class Period was to immediately recognize revenue upon the delivery of goods and services to the Big 3. This practice, however, ignored that the Big 3 refused to honor the terms of the contract by not paying Telestone or by paying the Company years later at their own discretion. Moreover, due to the Big 3's monopoly position and governmental states, [sic] Telestone admittedly was unable to do anything about this non-payment, refusing to demand payment or to seek legal recourse against these customers.

(Id. ¶ 5).

4   "GAAP is 'a technical accounting term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practices at a particular time." In re Ikon Office Solutions, Inc., 277 F.3d 658, 663 n. 2 (3d Cir. 2002) (citing American Institute of Certified Public Auditing Standards No. 69, ¶ 69.02 (1992)). "[The] single unified purpose of [GAAP] ... [is] to increase investor confidence by ensuring [*8]  transparency and accuracy in financial reporting." Gould v. Winstar Communications, Inc., 692 F.3d 148, 153 n.5 (2d Cir. 2012)

With regards to the Moving Defendant, Mazars CPA, Plaintiff alleges that "[i]n spite of the clear evidence of Telestone's customers not honoring its purported contracts with the Company, Telestone's auditors simply buried their heads in the sand and rubber-stamped the Company's conclusions regarding the propriety of its revenue recognition policy." (Id. ¶ 10). Thus, Plaintiff claims that Mazars CPA, through its Audit Reports issued during the class period, materially misrepresented to investors that Telestone's financial reports reliably represented the Company's financial status, that these financial reports were GAAP-compliant, and that the Audit Reports themselves were compliant with Generally Accepted Auditing Standards ("GAAS").⁵

5   "GAAS are the standards prescribed by the Auditing Standards Board of the American Institute of Certified Public Accountants for the conduct of auditors in the performance of an examination." In re Ikon, 277 F.3d at 663, n. 5.

According to the Amended Complaint, the market gradually learned that there may have been an issue with Telestone's revenues when its accounts receivable figures ballooned, which resulted in the Company's stock price [*9]  declining significantly during the Class Period. (Id. ¶¶ 11-14, 138). Specifically, on May 15, 2012, August 14, 2012, and November 19, 2012, Telestone issued three press releases disclosing that its accounts receivable and accounts receivable turnover period were greatly increasing. (Id. ¶ 138). Plaintiff now alleges violations of Section 10(b) of the Securities Exchange Act against all Defendants, and violations of Section 20(a) of the Act against the individual Defendants. (Id. at 81-86). Defendant Mazars CPA now moves to dismiss the claims against it. (Def s. Mov. Br.). Plaintiff has opposed this motion (ECF No. 38, "Pl's. Opp. Br."), and Mazars CPA has filed a reply to that opposition (ECF No. 41, "Def s. Reply Br.").

***

i. Plaintiff's Pleading of the "Collective Scienter"

Mazars CPA argues that Plaintiff has failed to sufficiently plead scienter under the PSLRA and Rule 9(b)'s heightened pleading requirements. (Def.'s. Mov. Br. at 22-35). As a preliminary matter, Mazars CPA contends that Plaintiff improperly relies on the "collective scienter" of Mazars CPA rather than pleading the scienter of "at least one individual officer who made, or participated in the making of, a false or misleading statement," as [*35]  Mazars CPA contends is required. (De's. Mov. Br. at 15-16). Even if it were appropriate for Plaintiff to plead the collective (or "corporate") scienter, Mazars CPA alleges that such pleading is only appropriate under "extraordinary circumstances" not found in the Amended Complaint. (Der s. Mov. Br. at 16). Plaintiff does not directly respond to the argument that it has improperly pled the "collective scienter."

The circuits are split on the question of whether a plaintiff may meet the strict pleading requirements of the PSLRA by pleading the "collective" or "corporate" scienter. The Fifth Circuit, for example, has held that plaintiffs must plead that at least one individual acting on behalf of the corporation made a false statement with the requisite state of mind. See Southland Securities Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353, 366-67 (5th Cir. 2004). By contrast, the Second, Sixth, Seventh, and Ninth Circuits have approved the viability of the collective scienter doctrine while nonetheless upholding the strict pleading requirements of the PSLRA. Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital, 531 F.3d 190, 195 (2d Cir. 2008); City of Monroe Employees Retirement Syst. v. Bridgestone Corp., 399 F.3d 651, 684, 689-90 (6th Cir. 2005); Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702, 710 (7th Cir. 2008); Glazer Capital Mngmt, LP v. Magistri, 549 F.3d 736, 744 (9th Cir. 2008).

While the Third Circuit has not definitively decided whether a plaintiff can plead the collective scienter with regards to PSLRA claims, it has indicated that it may be possible to plead scienter against a corporation [*36]  without pleading scienter against an individual.⁹ City of Roseville Employees' Retirement Sys. v. Horizon Lines, Inc., 442 Fed. Appx. 672, 676-77 (3d Cir. 2011) (unpublished); see also Rahman v. Kid Brands, Inc., 736 F.3d 237, 246 (3d Cir. 2013). Courts have found collective scienter to satisfy the pleading standard where "the pleaded facts [] create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter." Dynex, 531 F.3d at 195; see also Tellabs. 513 F.3d at 711 (stating that where a "dramatic announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false," a "strong inference of corporate scienter" would arise).

9   Likewise, this Court has previously declined to hold that a plaintiff in a Section 10(b) pleading may never meet the scienter requirement by pleading the collective scienter. See Rahman v. Kid Brands, Inc., Civ. No. 11-1624, 2012 WL 762311 at *17 (D.N.J. Mar. 8, 2012) (Linares, J.), aff'd 736 F.3d 237, 246 (3d Cir. 2013).

Here, the Audit Reports containing the allegedly material false statements were signed by "Mazars CPA Limited" as an entity. (See Compl. ¶¶ 124-127). In fact, the Audit Reports do not appear to be signed by a known, named individual auditor.¹⁰ However, given that these Reports were presumably approved by a senior auditor and for disclosure to the public in compliance with financial reporting requirements, the Court finds that the pleaded facts and allegations as [*37]  to scienter, discussed in detail below, "create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter." Dynex, 531 F.3d at 195. Accordingly, the Court will not dismiss Plaintiffs claims against Mazars CPA at the juncture for failing to plead scienter as to a specific individual related to the Defendant.

10   At this stage of the litigation, and given that the Audit Reports were not signed by a specific auditor, it is unclear how Plaintiff would be able to identify any specific auditor.