Opinion
Civil Action No. 22-00545 (MEF)(LDW)
2023-08-15
Scott HACKER, et al., Plaintiffs, v. ELECTRIC LAST MILE SOLUTIONS INC., et al., Defendants.
Laurence M. Rosen, The Rosen Law Firm, P.A., Newark, NJ, for Plaintiffs. Blake T. Denton, Latham & Watkins LLP, New York, NY, for Defendants Electric Last Mile Solutions Inc., Albert Li, Robert Song. Joseph Andrew Matteo, Barnes & Thornburg LLP, New York, NY, for Defendant James Taylor. Alison Rebecca Benedon, Paul, Weiss, Rifkind, Wharton & Garrison LLP, New York, NY, for Defendant Jason Luo. Blake T. Denton, Latham & Watkins LLP, New York, NY, Michael S. Doluisio, Dechert LLP, Philadelphia, PA, for Defendants David Boris, Marshall Kiev. David William Kiefer, McDermott Will & Emery LLP, New York, NY, for Defendant BDO USA, LLP.
Laurence M. Rosen, The Rosen Law Firm, P.A., Newark, NJ, for Plaintiffs. Blake T. Denton, Latham & Watkins LLP, New York, NY, for Defendants Electric Last Mile Solutions Inc., Albert Li, Robert Song. Joseph Andrew Matteo, Barnes & Thornburg LLP, New York, NY, for Defendant James Taylor. Alison Rebecca Benedon, Paul, Weiss, Rifkind, Wharton & Garrison LLP, New York, NY, for Defendant Jason Luo. Blake T. Denton, Latham & Watkins LLP, New York, NY, Michael S. Doluisio, Dechert LLP, Philadelphia, PA, for Defendants David Boris, Marshall Kiev. David William Kiefer, McDermott Will & Emery LLP, New York, NY, for Defendant BDO USA, LLP. OPINION Michael E. Farbiarz, United States District Judge
Table of Contents
I. Background
A. Procedural History
B. The Complaint
C. The Motion to Dismiss II. Pleading Standards III. Scienter
A. Legal Principles
B. A "Strong Inference" of Scienter
1. Red Flag: Share Price
2. Red Flag: Share Valuation
3. Context
4. GAAP Violations
5. Motive
6. Conclusion
C. Other Inferences IV. Misrepresentation of "Fact"
Investors sued an auditor, among others, alleging certain financial statements were inaccurate because they did not fully reflect operating expenses.
The auditor now moves to dismiss, on two grounds.
First, it is argued, the investors did not make sufficient allegations about the auditor's mental state. This argument is not persuasive.
Second, it is argued, the auditor's opinion about the financial statements did not amount to an actionable misrepresentation of fact. Consideration of this argument is held in abeyance. The Third Circuit Court of Appeals recently issued an important decision on this point. The parties should have a chance to address it.
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I. Background
A. Procedural History
This case, a putative class action, was initiated by a complaint filed during February 2022. An amended complaint was filed in October 2022.
On May 31, 2023, the case was re-assigned to the undersigned.
Since then, two main things have happened.
First, a proposed settlement was floated. It reached certain defendants, but not all.
In brief: on June 28, the Plaintiffs moved for an order preliminarily approving a proposed settlement; on July 25, the Plaintiffs filed a "notice of non-opposition" to the motion; and on August 1, the Court denied the motion. The motion was intended as a prelude to notifying class members of a proposed settlement. But under Federal Rule of Civil Procedure 23(e)(1)(B), notice may only be given if the Court "will likely be able to" approve the settlement. And in its ruling on August 1, the Court held that it had not been provided with enough information to make that determination. On August 8, the Plaintiffs filed a new motion. No notice of non-opposition has yet been filed.
Second, a motion to dismiss, made by a defendant that was not part of the proposed settlement, became fully submitted.
In particular, the above-referenced auditor, referred to from here as "the Defendant," filed a motion to dismiss on April 11. The opposition was filed on June 12, and the reply was filed on July 24.
The Defendant is BDO USA, LLP.
The Defendant's motion is now before the Court.
B. The Complaint
The Defendant's motion seeks to dismiss the amended complaint. What follows are the complaint's core allegations, as relevant for the moment.
For simplicity, the amended complaint will be referred to as "the complaint."
A public acquiring company and a private operating company signed a merger agreement during December 2020. See Complaint ¶ 38.
During 2021, the proposed merger was approved by a vote of the acquiring company's shareholders. See id. ¶ 39. The vote was taken based on a range of information, including the operating company's 2020 audited financial statements. See id. ¶ 12.
The public acquiring company was a so-called special purpose acquisition company. The type of merger described in the text is a "de-SPAC transaction." It is a way to take a private company public. Here, the private company being taken public was the operating company.
The newly-combined public company registered with regulators. See id. ¶¶ 39, 61. The registration included the 2020 financial statements. See id. ¶¶ 12, 61.
The 2020 financial statements were audited by the Defendant. See id. ¶ 76. The Defendant gave the financial statements a "clean opinion." See id.
"An 'unqualified' or 'clean' audit opinion is the highest level of assurance that an auditor can give on an organization's financial statements. Accountants will 'qualify' their opinion where discrepancies are identified in a client's financial statements." In re Ikon Off. Sols., Inc., 277 F.3d 658, 663 n.4 (3d Cir. 2002).
During 2022, the merged public company announced the 2020 financial statements would need to be restated because of accounting errors. See id. ¶¶ 66-67. The day after the announcement, the public company's share price fell by about half. See id. ¶ 68.
The basis of the 2022 announcement: during 2020, before the merger was completed, the private operating company had issued shares for the benefit of certain of its employees. These, it was said, were not properly accounted for in the 2020 operating company financial statements the Defendant had audited. See id. ¶¶ 66, 67.
All of this allegedly hurt two sets of investors. First, some of the post-merger investors --- the shares they bought were assertedly worth less because of the accounting issues. See id. ¶¶ 68, 94. And second, some of the pre-merger investors --- who had been asked to vote on the merger based on the 2020 financial statements that would need restating. See id. ¶¶ 12, 39, 94.
Investors meeting these specs sued, seeking to initiate a class action on behalf of themselves and others similarly situated. See id. ¶¶ 94-99.
The investors are referred to from here as "the Plaintiffs."
C. The Motion to Dismiss
The Plaintiffs' lawsuit is based on the theory that in issuing its clean opinion on the 2020 operating company financial statements the Defendant violated Section 10(b) of the Securities Exchange Act of 1934, and in particular a regulation under the Act typically called "Rule 10b-5." See id. ¶¶ 102-11.
The Rule provides in relevant part: "It shall be unlawful for any person . . . [t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading . . . in connection with the purchase or sale of any security." 17 C.F.R. § 240.10b-5(b).
A Rule 10b-5 claim "has six elements: (i) a misrepresentation or omission of material fact; (ii) scienter; (iii) a connection with the purchase or sale of a security; (iv) reliance; (v) economic loss; and (vi) loss causation." City of Warren Police & Fire Ret. Sys. v. Prudential Fin., Inc., 70 F.4th 668, 679 (3d Cir. 2023).
The Defendant, as noted, has now moved to dismiss, and focuses on the first two elements.
First, as noted, Rule 10b-5 imposes liability only when a person or entity acts with "scienter." Id. But, the Defendant argues, the Plaintiffs have not shown it had this mental state when it issued the clean opinion. See Defendant's Memo at 17-29.
" '[S]cienter' " refers to a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976).
The Plaintiffs' and Defendant's opening memoranda of law are referred to as "Plaintiffs' Memo" and "Defendant's Memo." The Plaintiffs' reply memorandum of law is not cited.
Second, Rule 10b-5 is concerned with "a misrepresentation or omission of material fact[.]" City of Warren Police & Fire Ret. Sys., 70 F.4th at 679. But, the Defendant argues, the clean opinion it issued on the 2020 financial statements was a statement of opinion, not fact. Rule 10b-5, the argument goes, is therefore largely inapplicable. See Defendant's Memo at 10-17.
These arguments are taken up below, in Part III (scienter) and Part IV (facts versus opinions), after a brief discussion in Part II of pleading standards that are relevant to both Part III and Part IV. II. Pleading Standards
In deciding a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), as this one is, the Court is "required to accept as true all factual allegations in the complaint and draw all inferences from the facts alleged in the light most favorable to [the plaintiff]." Phillips v. Cnty. of Allegheny, 515 F.3d 224, 228 (3d Cir. 2008).
Motions to dismiss are assessed as follows.
First, the Court "must tak[e] note of the elements [a] plaintiff must plead to state a claim." Connelly v. Lane Constr. Corp., 809 F.3d 780, 787 (3d Cir. 2016) (quoting Ashcroft v. Iqbal, 556 U.S. 662, 675, 129 S.Ct. 1937, 173 L.Ed.2d 868 (2009)).
See Part I.C above.
Second, the Court must identify those allegations in the complaint that are merely conclusory, and set them to one side as irrelevant to the analysis. See id.
Third, the Court must determine whether the remaining allegations "plausibly give rise to an entitlement to relief." Connelly, 809 F.3d at 787 (quoting Iqbal, 556 U.S. at 679, 129 S.Ct. 1937).
Two additional pleading strictures apply here: first, Federal Rule of Civil Procedure 9(b), because this case sounds in fraud; and second, the Private Securities Law Reform Act, or "PSLRA."
[Plaintiffs who] allege fraud [as the Plaintiffs do here] . . . must state with particularity the circumstances constituting fraud or mistake." Fed. R. Civ. P. 9(b). Moreover, . . . the PSLRA imposes greater particularity requirements concerning alleged material misrepresentations and scienter. A complaint must "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation . . . is made on information and belief . . . all facts on which that belief is formed." 15 U.S.C. § 78u-4 (b)(1). Concerning scienter, a complaint must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4 (b)(2)(A). The PSLRA's heightened standard exists "to curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims." Tellabs, Inc. v. Makor Issues & Rts, Ltd., 551 U.S. 308, 322, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007).Fan v. StoneMor Partners LP, 927 F.3d 710, 714-15 (3d Cir. 2019); see also In re Rockefeller Ctr. Props., Inc. Sec. Litig., 311 F.3d 198, 224 (3d Cir. 2002) (noting that Rule 9(b) and the PSLRA "impose independent, threshold pleading requirements that, if not met, support dismissal apart from Rule 12(b)(6)"). III. Scienter
In light of the pleading standards set out above, the Court analyzes the Defendant's first argument: that the Plaintiffs have not adequately pled scienter, and that their complaint must therefore be dismissed. See Defendant's Memo at 17-29.
As to the scienter analysis, Part III.A below sets out the relevant legal principles and Parts III.B and III.C apply them.
A. Legal Principles
As noted, for a Rule 10b-5 claim, the "required state of mind is scienter --- the intent to deceive, manipulate, or defraud either knowingly or recklessly." Pamcah-UA Loc. 675 Pension Fund v. BT Grp. PLC, 2021 WL 3415060, at *1 (3d Cir. Aug. 5, 2021).
Here, the Plaintiffs argue the Defendant was reckless. See Plaintiffs' Memo at 12. Recklessness is "not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care[.]" Institutional Invs. Grp. v. Avaya, Inc., 564 F.3d 242, 267 n.42 (3d Cir. 2009) (cleaned up).
Because scienter is a state of mind, it must often be established indirectly. It must be "inferred."
To be legally sufficient, an inference of scienter must be "strong." 15 U.S.C. § 78u-4(b)(2)(A). "A complaint adequately pleads a strong inference of scienter 'only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.' " In re Hertz Glob. Holdings Inc., 905 F.3d 106, 114 (3d Cir. 2018) (quoting Tellabs, 551 U.S. at 324, 127 S.Ct. 2499). This "is not easy to allege." Pamcah-UA Loc. 675 Pension Fund, 2021 WL 3415060, at *1.
This case, as noted, is a Rule 10b-5 challenge to an auditor's statements, and the motion before the Court is a motion to dismiss.
For contexts such as this one, the Court of Appeals has provided additional guidance as to one particular way the inference of scienter can potentially be plead in a "strong" and legally sufficient manner:
At the pleading stage, courts have recognized that allegations of GAAS violations, coupled with allegations that significant "red flags" were ignored, can suffice to withstand a motion to dismiss. See, e.g., In re Daou, 411 F.3d at 1016; Greebel v. FTP Software, Inc., 194 F.3d 185, 203 (1st Cir. 1999); Malone v. Microdyne Corp., 26 F.3d 471, 479 (4th Cir. 1994). Such allegations, of course, must be pled with particularity. In re Daou, 411 F.3d at 1016. It is insufficient, for example, for a plaintiff to cite GAAS standards without an explanation of how the defendant knowingly or recklessly violated those standards. In re Westinghouse Sec. Litig., 90 F.3d 696, 712 (3d Cir. 1996).In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 279-80 (3d Cir. 2006); see also, e.g., In re Valeant Pharms. Int'l, Inc. Sec. Litig., 2023 WL 3993740, at *4 (D.N.J. June 14, 2023) (applying this standard).
"GAAS," as alluded to in the quote, is generally accepted auditing standards. "GAAP" is generally accepted auditing principles. These are closely related, and are often treated as synonyms by courts. That is how the Court will proceed here.
B. A "Strong Inference" of Scienter
To decide if scienter was adequately pled in light of the principles set out above, the Court first "determine[s] whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard." Martin v. GNC Holdings, Inc., 757 F. App'x 151, 154 (3d Cir. 2018) (emphasis in original, cleaned up).
While the ultimate task is "collective[ ]," it is helpful to begin with "individual" pieces before adding them up. Id. The individual pieces are discussed below, in Parts III.B.1, III.B.2, III.B.3, III.B.4, and III.B.5. The Court's overall, "collective" assessment is in Part III.B.6.
1. Red Flag: Share Price
As noted above, "[a]t the pleading stage, courts have recognized that allegations of GAAS violations, coupled with allegations that significant 'red flags' were ignored, can suffice to withstand a motion to dismiss." In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d at 279.
The first red flag, the Plaintiffs argue, was the price per share ($10) at which the shares of the operating company were issued during November 2020. See Plaintiffs' Memo at 10-12.
To see the argument, zero in on the 2020 timeline. The relevant allegations are as follows.
For 2020, there were two bookends. First, in September 2020, a letter of intent to merge was signed. See Complaint ¶ 37. And second, in December 2020, a merger agreement was signed. See id. ¶ 38. Under the letter, after the merger was complete, the merged public company would hand over 820 or so of its shares for every share of the acquiring company. See id. ¶ 5.
The precise number: 821.17. See id. ¶ 5.
Between these September-and-December bookends, during November of 2020, the operating company issued and sold shares, 99,000 of them. See id. ¶ 7. The price of the shares was set by the operating company at $10. See id. ¶ 40.
At the moment the private operating company issued its shares, the public acquiring company's shares were trading for $10 each. See id. ¶ 63 n.6.
As noted in the text, the $10 share price of the public acquiring company is alleged in the complaint. This allegation, though, is somewhat elliptical. The public company share price also comes before the Court in a "price chart" filed alongside the Plaintiffs' brief. Such price charts are routinely considered, even in the context of motions to dismiss such as this one. See, e.g., In re Amarin Corp. PLC Sec. Litig., 2021 WL 1171669, at *8, *10 (D.N.J. Mar. 29, 2021), aff'd, 2022 WL 2128560 (3d Cir. June 14, 2022).
Against this backdrop, the Plaintiffs' argument: it made little sense for each share of the operating company to be valued at $10, given that (a) after the merger each share would be traded in for 820 shares of the acquiring company and (b) the acquiring company's shares were themselves trading at $10 at the time of the November 2020 stock sale. That is, each share (of the operating company) would yield 820 shares (of the acquiring company), and because the acquiring company shares were trading at $10 --- each share of the operating company would net $8200 after the merger (820 acquiring company shares, worth $10 a piece). How can a share that is soon be worth $8200 be valued at just $10? See Plaintiffs' Memo at 10-12.
The Defendant's response: (1) it was no sure thing the merger would actually go through, (2) so the 820:1 exchange might never happen, (3) and the $10 share price was therefore of no concern. See Defendant's Memo at 24-26.
As to the first point: yes, true --- mergers fall through even after letters of intent and merger agreements are signed. And as to the second point: also true.
But the third point is the one that matters, and it does not follow from the first two. For anyone doing (or reviewing) a valuation analysis in a context like this one, it could potentially make sense to consider discounting share value to reflect the possibility the merger would not in the end actually get done. Of course. But even if there was a 1/3 chance of the merger not getting there, or even a 2/3 chance --- $10 is still hard to fathom for a share that could soon be worth $8200.
A discount rate that assumes even a 1/3 failure likelihood for a merger might be high. See, e.g., Muhammad Farooq Ahmad, et al., Does Bilateral Trust Matter During Mergers and Acquisitions Negotiations?, Brit. J. of Mgmt. 1, 1 (2022) ("[T]he proportion of agreed and publicly announced transactions that fail to close is between 8% and 15%."); Fred Bereskin, et al., The Effect of Cultural Similarity on Mergers and Acquisitions, 53 J. of Fin. and Quantitative Analysis 1995, 2012 (2018) ("In large samples, the failure rate for an M&A bid for a publicly traded target . . . is approximately 10%-15%[.]"); Robert Campbell, et al., Once Bitten, Twice Shy: Failed Deals and Subsequent M&A Cautiousness, Ctr. for Fin. Research Working Paper, No. 22-09, 2022, at 2 ("about 10 percent of all large mergers and acquisitions are canceled") (cleaned up).
And all the more so here. The risk of not getting to the finish line is usually lower towards the homestretch of a race. And that is precisely where everyone was when the operating company shares were valued at $10. The letter of intent had already been signed. And the execution of the merger agreement was less than three weeks away, which means it likely was very far along in terms of being negotiated. That is close to the end. At that point, whatever risk needed to be priced in that the merger would not be completed was likely lower than higher.
The ultimate finish line, it might be said, was the final consummation of the merger. But that was not very far off either. The acquiring company was a special purpose acquisition company, see footnote 4, and going public by means of such a company is not usually a very lengthy process (at least as compared to the typical alternative, going public via an initial public offering). See, e.g., Vinay Datar, et al., Going Public Through the Back Door: A Comparative Analysis of SPACs and IPOs, 4 Banking & Fin. Rev. 17, 19 (2012) ("SPAC merger is quicker . . . than an IPO"); accord, e.g., Ramey Layne and Brenda Lenahan, Special Purpose Acquisition Companies: An Introduction, Harvard Law School Forum on Corporate Governance (July 6, 2018) ("As compared to operating company IPOs . . . , SPAC IPOs can be considerably quicker."); see also Max H. Bazerman and Paresh Patel, SPACs: What You Need to Know, Harvard Bus. R. (July-August 2021) ("[f]or targets, the entire SPAC process can take as little as three to five months, . . . whereas traditional IPOs often take nine to 12 months").
Put differently: if a merger would turn one share (of the operating company) into $8200, it would be hard to justify a price of just $10 for the share unless the chance of the merger going through was close to zero. But why would anyone think that? The letter of intent to merge was signed, and the merger agreement was less than three weeks away. The operating company going public was no far-off blip on the horizon.
To be sure, there are likely any number of possible responses to all this. Maybe the merger would hurt the acquiring company's share price. Or maybe many of the acquiring company's shareholders needed hard convincing or were planning to redeem their shares. Or maybe key deal points were hashed out only at the last minute, such that agreement on basic commercial terms (and the implicit "de-risking" that comes with such agreement) happened later-in-the-game than is typical. All of these are possibles.
But the Defendant does not make any arguments along these lines. And in any event, there is no basis for them in the current record, and they hardly need evaluating now.
This is because the question, now, is not about the final, bottom-line merits of the case. It is not about whether the 820:1 exchange ratio was a black-and-white checkered flag --- a signal that the race is over and done, because the exchange ratio speaks for itself and establishes that the $10 valuation was inappropriate.
Rather, the question for now is whether the 820:1 ratio was a red flag --- a signal of possible danger around the curve. This is not about the case's final merits. It is a question about whether the auditor should have perceived possible trouble ahead, and slowed down. It should have --- the $10 per share price was "startling." Globis Cap. Partners, L.P. v. Stonepath Grp., Inc., 241 F. App'x 832, 836 (3d Cir. 2007). In the context of the soon-to-be-signed merger agreement, the combined effect of the 820:1 ratio and the $10 acquiring company share price was to throw up a red flag --- indicating the $10 operating company share valuation was much too low.
A red flag, yes. But warning of what? And to whom?
As to the first question, the Plaintiffs allege, the red flag was a warning that the operating company's 2020 financial statements (that the Defendant audited) were inaccurate. And as to the second question, the Plaintiffs allege, the warning reached the Defendant.
Take each of these in turn.
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First: how would a too-low 2020 valuation of the operating company's shares impact the accuracy of its 2020 financial statements? The November 2020 operating company stock sale was for the benefit of certain company employees, see Complaint ¶ 7, and compensation of employees is an expense. See id. ¶ 10. The correct compensation expense needed to have been reflected in, among others, the "total operating expenses" line on the operating company's financial statements.
Here, it is alleged, the correct compensation expense associated with the November 2022 stock sale should have been reported based on the difference between (a) the fair market value of the operating company shares issued and sold in November 2020 and (b) the $10 price at which they were actually issued and sold. See id. ¶ 10.
And if that had been done, the Plaintiffs allege, there would have been a plainly material impact on the total expenses line of the 2020 operating company financial statements --- a jump from around $7 million to around $700 million. See id. ¶¶ 61-65.
Note that these calculations are, on their own terms, a bit high. The $700 million figure reflects the alleged combined impact on the 2020 audited financial statements (a) of the November 2020 sale (of 99,000 shares at $10 per share, as already discussed), and also (b) of a December 2020 stock sale (of 1,000 shares at $10 per share). The December 2020 stock sale is discussed below. Backing out the impact on total operating expenses of the December 2020 stock sale would yield a number somewhat lower than $700 million, but still easily material.
These calculations are plead in a manner that is plausible enough and particular enough. See Part II (setting out relevant pleading standards). And they matter here because they show that the "startling[ly]" low $10 price for operating company shares was a red flag --- and one that suggested the 2020 financial statements the Defendant offered its "clean opinion" on were materially inaccurate, because they greatly understated operating expenses.
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This leads to the second questions: could the Defendant see the red flag? Was it aware of the November 2020 stock sale at the time (May 2021) when it issued its clean opinion?
See generally In re Suprema Specialties, 438 F.3d at 280-81 (red flag weighs against grant of motion to dismiss in part because it was an "obvious and readily available indicator" of concern to the auditor); see also, e.g., Sun v. Han, 2015 WL 9304542, at *17 (D.N.J. Dec. 21, 2015) ("the inquiry should revolve around the 'red flags' available to [the auditor] at the time that it issued its Audit Reports."); accord Se. Pa. Transp. Auth. v. Orrstown Fin. Servs., Inc., 2022 WL 3572474, at *51 (M.D. Pa. Aug. 18, 2022).
To answer, come back to the timeline. The November stock sale happened (in 2020), and the merger was completed (in 2021). In 2022, the merged entity conducted an internal investigation; issued a Form 8-K; and then, on February 9, allegedly wrote a letter to the Defendant:
Under Section 13 of the Securities Exchange Act of 1934, companies must make certain public reports, and the Securities and Exchange Commission can establish standard forms on which the reports will be made. One of the SEC-established standard forms is a "Form 8-K."
To the extent that you claim that you were only recently made aware of the equity transactions described in the Form 8-K, we remind you that BDO Tax was involved in structuring such transactions and that, as you have confirmed to us, BDO USA was aware of those transactions well in advance of and in connection with completion of the audit. The transactions were contemporaneously discussed with multiple professional advisors, including representatives of BDO.Complaint ¶ 79.
Recall that the Defendant is BDO USA, LLP.
What to infer from this? To answer this question, start with another: Does "equity transaction[ ]" in the above-quoted February 9, 2022 letter mean the November 2020 stock ("equity") sale ("transaction[ ]")? Yes. That is the only reasonable inference. The "Form 8-K" referenced in the February 9 letter is virtually certain to be the public company's February 1, 2022 Form 8-K filing. See generally Complaint ¶¶ 13, 71. And that filing refers to the November 2020 stock sale, another stock sale, see footnote 16, and nothing else that could possibly fit the bill.
It also meant another stock sale, from December 2020. That December 2020 stock sale was alluded to above, see footnote 16, and is discussed below. See Part III.B.4.
The Court has reviewed the 8-K. Its contents are described throughout the complaint. And such filings are routinely considered, even in the context of motions to dismiss such as this one. See, e.g., In re Amarin Corp. PLC Sec. Litig., 2021 WL 1171669, at *8-10.
The necessary inference is that when the February 9 letter to the Defendant referred to "equity transactions," everyone understood that included the November 2020 stock sale.
In response to the February 9 letter, the Defendant allegedly wrote:
BDO does not have a group named the "Tax Advisory Group", BDO did not help create and structure the Transactions nor does BDO have any basis of knowing what facts or circumstances resulted in the resignations of Mr. Luo or Mr. Taylor[.]Complaint ¶ 80.
Luo was the operating company's co-founder, president, and executive chairman. See Complaint ¶ 24. Taylor was the operating company's co-founder and chief executive officer. See Complaint ¶ 25. According to the Form 8-K, see footnote 21, Luo and Taylor resigned from the post-merger public company on February 1, 2022.
From this February 2022 back-and-forth, what is the reasonable inference?
The Court's answer: the Defendant was aware of the November 2020 stock sale when, in 2021, it audited the operating company's 2020 financial statements.
First, the assertions in the February 9 letter are specific, and describe multiple occasions on which the Defendant was aware of the November 2020 stock sale --- while it was happening ("contemporaneously," "well in advance of . . . the audit") and also after the fact, when the audit was being conducted ("and in connection with completion of the audit").
Second, the February 9 letter asserted the Defendant was aware of the November 2020 stock sale, and the Defendant did not deny this. Declining to dispute an accusation is not generally telling. But when the accusation is prefaced with "as you have confirmed to us," staying silent can be a bit more clarifying. After all, it is typically straightforward enough to say: "I did not confirm that to you." And the point is stronger in the context of a long-term relationship. Here, the Defendant was being accused by a company for which it had been serving as the auditor for about six months. See Complaint ¶ 29.
Third, the Defendant's response to the February 9 letter denied one accusation about the November 2020 stock sale ("[the Defendant] did not help create and structure" the sale) but did not deny the other accusation ("BDO USA was aware of those transactions well in advance of and in connection with completion of the audit").
What to make of this? One possibility: the Defendant missed the second accusation. Another: the Defendant believed the second accusation was false, but opted not to press the point.
But these are unlikely. The Defendant's response to the February 9 letter was written in a particular way --- with a close-in focus on the precise accusations made against it, and with a pugnacious approach that took advantage of what it could.
In response to the assertion that "BDO Tax was involved in structuring [the relevant] transactions," Complaint ¶ 79, the Defendant's letter said: "BDO does not have a group named the 'Tax Advisory Group[.]' " Id. ¶ 80. But the complaint alleges that the Defendant's website says it "delivers . . . tax . . . advisory services[,]" such that "even if BDO does not have a practice precisely named 'Tax Advisory Group' that does not mean BDO does not provide tax advisory services." Id. ¶ 81.
The suggests a third possibility, which the Court views as a good deal more likely: that the Defendant denied the first accusation about the November 2020 stock sale (that it helped structure it), but not the second accusation about the stock sale (that it was aware of it), because it knew the second accusation was accurate.
Taking all of the above together, the Court concludes that the reasonable inference from the February 2022 back-and-forth set out above is that the Defendant was aware of the November 2020 stock sale when, in 2021, it audited the 2020 financial statements.
This inference is based on "practical . . . common sense," and that has a place here. And it is further strengthened by two additional points.
See Institutional Invs. Grp., 564 F.3d at 272-73 ("In assessing . . . [scienter] allegations holistically . . . , the federal courts certainly need not close their eyes to circumstances that are probative of scienter viewed with a practical and common-sense perspective.") (cleaned up).
First, there is no suggestion that the November 2020 stock sale was obscure. Indeed, the November 2020 stock sale was described publicly (and in sufficient detail) by the acquiring company in July 2021, in the public registration statement it filed just after the merger vote. See Complaint ¶¶ 12, 90.
Second, and as alluded to above, the Defendant was the private operating company's auditor from its inception (in August 2020) through to the end of that year. See Complaint ¶¶ 12, 29. And pricing of a major stock issuance (undertaken in November 2020) is the sort of thing that company management would be expected to consider consulting with their outside auditor on. There are, for example, potential tax consequences to attend to. And consultation with the outside auditor was all the more likely here, when: (a) the auditor had tax expertise, and, as will be discussed below, (b) the in-house staff at the private operating company was relatively inexperienced, such that it would especially make sense to look outside for assistance.
See footnote 29 below.
See footnote 23 above.
The best inference from all the allegations, the Court concludes, is that the Defendant was aware of the November 2020 stock sale when it issued its clean opinion on the 2020 financial statements. This is a reasonable inference, and the Plaintiffs are entitled to it. See generally In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d at 281 (holding, in the context of a lawsuit against an auditor, that "plaintiffs are entitled to the benefit of all reasonable inferences based on the detailed and specific allegations in their complaints").
Three points. First, the registration materials issued in July 2021 were published about two months after the Defendant issued its clean opinion as to the operating company, and about one month before the Defendant became the public company's auditor. This does not detract from the inference set out in the text. (Indeed, it supports it to an extent.) Second, the discussion in the text is belt-and-suspenders. In spite of the issue being clearly teed-up, see, e.g., Complaint ¶¶ 78-82; Plaintiff's Memo at 7, 10, the Defendant nowhere meaningfully argues the Plaintiffs have not sufficiently alleged that it (the Defendant) was aware of the November 2020 stock sale when it issued its clean opinion. See, e.g., Barna v. Bd. of Sch. Dir. of Panther Valley Sch. Dist., 877 F.3d 136, 147 (3d Cir. 2017). Third, an auditor who knew of the November 2020 stock sale almost certainly would know about its basic terms, and also their connection to the merger --- the then-$10 price of acquiring company shares, and the 820:1 ratio. Moreover, the $10 price of the acquiring company's shares, then as now, was on the internet. And the 820:1 ratio was allegedly included in the September 2020 letter of intent to merge, see Complaint ¶ 5 --- and it is highly likely that in auditing the operating company's 2020 financial statements, the Defendant reviewed the letter.
* * *
In sum, the Plaintiffs have alleged with the requisite particularity and plausibility that the $10 operating company share valuation used in connection with the November 2020 stock sale was a red flag. It suggested the financial statements audited by the Defendant were potentially erroneous, and by a material amount. And this red flag was visible to the Defendant because it was aware of the November 2022 stock sale (and before it issued its clean opinion on the financial statements). Scienter can rest, in part, on red flags of this kind. In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d at 279-80; cf., e.g., N.M. State Inv. Council v. Ernst & Young LLP, 641 F.3d 1089, 1098-99 (9th Cir. 2011) (focusing on "timing" and "relative size" of "the largest option grant in the company's young history," and the fact that its "potential . . . impact on . . . earnings was material" in holding that auditors acted with scienter).
Another way to see things: the Defendant's awareness of the November 2020 stock sale was not a red flag that then suggested there could be problems with the 2020 financial statements. Rather, the Defendant's awareness of the November 2020 stock sale directly showed that it knew there could be problems with the 2020 financial statements. This would, if anything, be stronger proof of scienter.
2. Red Flag: Share Valuation
In addition to the above, the complaint alleges that although the operating company assigned a per-share price of $10, it did "not perform[ ] valuations" of its shares. See Complaint ¶¶ 91-92; see also id. ¶ 10.
This was another red flag.
Companies whose shares trade on liquid-enough markets may, in some circumstances, be able to simply treat the relevant day's market price as the fair market value of shares granted to an employee.
But in virtually every other circumstance, determining a share's fair market value requires a meaningful analysis. In the footnote is an excerpt from the regulations that describe a fair market valuation of private company shares in the (somewhat analogous) tax context. And there is a large literature on establishing fair market value in other contexts --- using, for example a comparable company analysis or a discounted cash flow analysis.
Per Treasury Regulation 1.409A-1(b)(5)(iv)(B):
[T]he fair market value of the stock . . . means a value determined by the reasonable application of a reasonable valuation method . . . . Factors to be considered . . . include . . . the value of tangible and intangible assets of the corporation, the present value of anticipated future cash-flows of the corporation, the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation the stock of which is to be valued, . . . and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes . . . . . . . . [An entity's] consistent use of a valuation method to determine the value of its stock . . . for other purposes, including for purposes unrelated to compensation . . . , is also a factor supporting the reasonableness of such valuation method.26 C.F.R. § 1.409A-1(b)(5)(iv)(B).
See, e.g., Samuel C. Weaver, et al., Merger and Acquisition Valuation, 20 Fin. Mgmt. 85, 90 (1991) ("[i]n valuing private firms . . . by far[ ] our most frequently used tool" is "discounted cash flow analysis"); Mary Samsa, Cracking the Code: Taxing Developments in Benefit Compliance, 28 No. 4 J. of Comp. & Benefits ART 3 (2014) ("most common three approaches": balance sheet approach, market comparable approach, and discounted cash flow approach); see also Joshua Rosenbaum and Joshua Pearl, Investment Banking 2 (2022) ("[c]omparable companies analysis . . . [is] one of the primary methodologies used . . . [and] provides a . . . benchmark . . . [to] establish valuation for a private company").
None of this is obscure, and none of it was obscure to the Defendant. From a publication published by the Defendant on "[g]oing [p]ublic" that "lists share-based compensation as one of nine high risk areas":
Registrants are required to measure and report all share-based compensation at fair market value. The calculations necessary to measure this compensation include assumptions about the company's share price volatility, interest rates, future dividends, and option life. As a result, many registrants are using appraisal advisors to calculate the value of the stock compensation grants.Complaint ¶ 87.
There are, in short, a number of ways to assess the fair market value of private company shares, each a bit different from the next. But each of these methods requires something: some fact-gathering, some analysis, some structured thinking. But the allegation here is that the operating company did nothing. See Complaint ¶ 92; see also id. ¶ 10.
In many circumstances, an auditor can, should, and must rely in some measure on work done by management. Cf. In re Ikon Off. Sols., Inc., 277 F.3d 658 at 672. But here, it is alleged, there was nothing done by management --- and, accordingly, there was nothing to look to, let alone to rely on.
A fair market valuation of nearly 100,000 shares of a company on the cusp of going public and that was anticipating a value of $1.3 billion, see id. ¶¶ 5, 8, could not have been left only to method-free diktat or a casual hunch. A valuation of at least some sort needed to have been performed. But this is what the complaint alleges did not happen.
The absence of any real method for evaluating the price of the operating company's shares was an obvious red flag, that strongly suggested the financial statements the Defendant was auditing, and to which it gave a clean opinion, could be materially inaccurate.
In addition, the Defendant was aware of this red flag. For the reasons set out in Part III.B.1, the complaint alleges the Defendant was aware of the November 2020 stock sale. And it is difficult to imagine a non-reckless auditor knowing of the stock sale but failing to ask management, as part of its audit of the financial statements, "How did you come to this valuation?"
Cf. In re Suprema Specialties, 438 F.3d at 280 (red flag weighs against motion to dismiss when it would have been apparent based "[e]ven on a cursory inquiry" from the auditor).
In sum, with enough particularity and plausibility, the Plaintiffs have alleged another red flag --- the operating company not preforming a valuation to establish the $10 share price. As before, this red flag was an especially important one. Scienter can rest, in part, on it. In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d at 279-80.
Cf. New Mexico State Inv. Council, 641 F.3d at 1098-99 (holding scienter established as to auditors, in the context of valuation of back-dated stock options used for employee compensation, in part because "it is hard to imagine how a reasonable auditor . . . would fail to obtain some documentation to verify [the auditee's] executive claim" as to the existence of a program that ameliorated the valuation concern); In re Wilmington Tr. Sec. Litig., 29 F. Supp. 3d 432, 449-50 (D. Del. 2014) (holding scienter established as to auditors, because GAAP "would require an auditor to . . . review the process used by management to develop [a certain figure]," but the auditor "did not request . . . any . . . required documentation"); In re Philip Serv. Corp. Sec. Litig., 383 F. Supp. 2d 463, 475 (S.D.N.Y. 2004) ("because the red flags would be clearly evident to any auditor performing its duties, one could reasonably conclude that [the auditor] must have noticed the red flags, but deliberately chose to disregard them") (cleaned up); see also In re Complete Mgmt. Inc. Sec. Litig., 153 F. Supp. 2d 314, 334 (S.D.N.Y. 2001) ("Here, plaintiffs make the critical allegation that if [the auditor] were conducting any kind of audit at all, they would have seen the potential problems . . . and the need to investigate further.").
3. Context
There are, as noted, two red flags here --- one substantive (the operating company shares were allegedly issued at an improbably low price) and one procedural (the shares were priced based on no meaningful method). These red flags are each important. And the broader context, described in this section, heightens their importance.
To see the point, focus on some aspects of the complaint not addressed until now.
There were 99,000 operating company shares issued at $10 per share in November 2020. See Complaint ¶ 7. Of these, 15% or so went to "four identified investors." Id. ¶ 8. About 75% went to an entity owned and controlled by one person. See id. And another 5% or so went to an entity controlled by another person. See id.
These last two people (who collectively received about 80% of the 99,000 shares) were the founders of the operating company. See id. ¶¶ 24, 25. And there was a large gap between the founders and everyone else. First, in terms of experience: the two founders were the only "executive officers [with] direct experience in the management of a publicly traded company." See id. ¶ 70. And there was also a gap in terms of stature in the organization: one of the founders (the one who received around 5% of the shares) served as the operating company's chief executive officer, see id. ¶ 25, and one of the founders (the one who received around 75% of the shares) served as the president and executive chairman. See id. ¶ 24. The two founders were, in short, the operating company's two senior-most leaders.
Moreover, the operating company was new. It was founded in August 2020, see id. ¶ 6, not long before the shares were issued during November 2020.
All of this provided an extra reason for the Defendant to be especially vigilant. The Defendant's "[g]oing [p]ublic" publication, described above, identifies the following as an issue to "look out for":
Cheap stock - common stock sold before a public offering at a price which is less
than the public offering process. Often, the stock is sold to company insiders.Id. ¶ 88.
The reason for this concern is not hard to see. When company shares are issued to a company's senior-most leaders, two things are yoked together: (a) possible motive, for the leaders to directly benefit themselves from undervalued shares; and (b) possible opportunity, because a company's senior-most leaders typically have broad influence on virtually all areas of a company's operations, including its accounting policies.
As to the extent of the influence of its senior leaders, note that, here, the operating company was new and its senior-most leaders were not surrounded by especially experienced personnel.
Auditors must be attuned to context in the way they go about their work. See, e.g., Public Company Accounting Board Accounting Standards 2110.04, 2110.65, and 2410.10. And the context described here is no exception.
That context only amplified the red flags described in the preceding two sections. A "startingly" low share valuation is a red flag, see Part III.B.1, and so is a share price fixed without performing a valuation, see Part III.B.2. And all the more so when the shares in question are issued and sold for the benefit of the company's senior-most leaders.
Cf. Omanoff v. Patrizio & Zhao LLC, 2015 WL 1472566, at *4-5 (D.N.J. Mar. 31, 2015) (holding that allegations supported auditor scienter in light of, among other things, "the context in which the audits were done," including that the auditee "was a new company with . . . employees who were not knowledgeable about U.S. accounting requirements").
4. GAAP Violations
As noted above, "[a]t the pleading stage, courts have recognized that allegations of GAAS violations, coupled with allegations that significant 'red flags' were ignored, can suffice to withstand a motion to dismiss." In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d at 279-80. Red flags have been discussed above, see Parts III.B.1 and III.B.2, as well as the context in which they appeared, see Part III.B.3.
Now, the Court turns to allegations of GAAS/GAAP violations. Two are alleged, and the Court concludes these are plead plausibly and with the required particularity.
See footnote 11.
First, the Plaintiffs pled GAAP violations related to the November 2020 stock sale.
This does not need to be belabored. It has been discussed above in Part III.B.1. And it is not clear from their papers that the Defendant even contends (for now) that the Plaintiffs have not alleged a GAAP violation.
This said, the allegations as to how the November 2020 stock issuance amounted to a violation of accounting principles are specific and detailed. Relevant principles are mustered, see Complaint ¶¶ 47-51, and so are the relevant underlying allegations, that explain how the accounting principles were violated by the treatment of the November 2020 stock sale. See id. ¶¶ 7-8, 40-45, 63-65.
While violations of GAAP standards may provide evidence of scienter, the complaint must describe the violations with sufficient particularity, e.g., the approximate amount by which revenues and earnings were overstated, the transactions involved, the identities of customers or employees involved in the transactions.Payne v. DeLuca, 433 F. Supp. 2d 547, 580 (W.D. Pa. 2006).
That standard is met.
There is a second alleged GAAP violation as well. This one concerns a December 2020 stock sale that has not yet been discussed. The core relevant allegations from the complaint are as follows.
One of the operating company's two founders (the executive chairman) owned another entity. That entity sold 1,000 shares of the operating company's stock during December 2020 for $10 per share. The 1,000 shares were sold to an entity jointly owned by the operating company's general counsel and chief operating officer. See id. ¶¶ 37, 46.
GAAP, it is alleged, required this to be reflected in the operating company's financial statements (a) as a capital contribution, and (b) as a compensation expense, measured by the difference between the fair market value of the operating company's shares (much more than $10) and the price that was paid for them ($10). See id. ¶¶ 56-58.
As with the November stock sale, the Defendant does not seem to press the argument that the Plaintiffs have failed to allege a GAAP violation as to the December 2020 stock sale.
And in any event, the allegations as to the December 2020 stock sale are also specific and detailed. Relevant accounting principles are set out, see Complaint ¶¶ 51-52, 56-58, and so are the relevant underlying allegations that explain how those principles were allegedly violated. See id. ¶¶ 9-10, 46, 63-65.
As before, the Payne v. DeLuca standard is met.
The Court concludes the Defendant was aware of the December 2020 transaction when it issued is clean opinion for the same reason the Court concludes the Defendant was aware of the November 2020 transaction. See above, at Part III.B.1. The "equity transactions" referred to in the February 2022 back-and-forth correspondence were the transactions referenced in the February 8-K, and those are the November 2020 and December 2020 stock sales. And as with the November stock sale, the Defendant does not in its briefs meaningfully contend that it was not aware of the December stock sale when it issued its clean opinion.
In sum, the Plaintiffs have plead two GAAP violations, one involving the November 2020 stock sale and one involving the December 2020 stock sale.
In addition, the Plaintiffs have set forth precise allegations as to the impact of these GAAP violations on the 2020 operating company financial statements the Defendant audited. Without the two GAAP violations, the Plaintiffs allege, the operating company's operating expenses would have gone from around $7.6 million to around $708 million. See Complaint ¶¶ 63-65.
These allegations are, necessarily, only one side of the story at this point. And they are allegations, not evidence. Are they sufficient out to the last dollar alleged? Hard to say, and unnecessary to say. Because the Plaintiffs' allegations are plausible and particular at least to the extent that they add up to GAAP violations that together imply a large-scale financial impact.
For now, that is enough. GAAP violations on even roughly this alleged scale, especially when based on relatively straightforward issues, support a strong inference that the Defendant acted with the sort of recklessness that can amount to scienter. See generally PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 684 (6th Cir. 2004) ("[A]n inference of knowledge or recklessness may be drawn from allegations of accounting violations that are so simple, basic, . . . and so great in magnitude, that they should have been obvious to a defendant."); In re Suprema, 438 F.3d at 281 ("[in] the face of the numerous and not insignificant alleged accounting violations, we cannot rule out, as a matter of law, a strong and reasonable inference of [auditor] scienter."); see also, e.g., In re Carter's, Inc. Sec. Litig., 2012 WL 3715241, at *2 (N.D. Ga. Aug. 28, 2012); Geinko v. Padda, 2001 WL 1163728, at *8 (N.D. Ill. Sept. 28, 2001); In re Leslie Fay Cos. Sec. Litig., 835 F. Supp. 167, 175 (S.D.N.Y. 1993).
"The size and scope of a company's restatement of prior financial statements is one factor that courts consider when conducting a scienter analysis." In re Hertz Glob. Holdings Inc., 905 F.3d 106, 116 (3d Cir. 2018). Here, there was no restatement, because after the February 2022 announcement the public company filed for bankruptcy protection. See Complaint ¶ 67 n.8. This lack of a restatement may make the to-the-dollar aspect of the Plaintiffs' allegations about the financial impact of the GAAP violations a bit less plausible. After all, a restatement is typically based on a fuller range of information than a plaintiff has at the pleading stage. Moreover, a major restatement sometimes relies on the work of a new set of auditors, who review the predecessor-auditors' work and help to correct and restate it. The views of such reviewing accountants may in some circumstances lend a bit of solidness to estimates (and may in some circumstances bear special weight, see In re Ikon Off. Sols., Inc., 277 F.3d at 669). But these are qualifications at the edges that do not alter the core point: the rough size of the GAAP errors' alleged financial impact was easily large enough to support a strong inference of scienter.
5. Motive
Before going further, it bears noting that the Plaintiff presses some additional arguments as to scienter, one of which the Court will consider here.
The complaint cites various accounting standards that require auditors to be sufficiently independent, and to apprise the auditee as to certain relationships that "may reasonably be thought to bear on independence." Complaint ¶ 77.
The Plaintiffs allege these standards were violated by the Defendant. To see how, recall that after the merger (in 2021) the public company hired the Defendant to serve as its auditor. See Complaint ¶ 29. At some point after that, it is alleged, the public company
stated it did not receive written communications from [the Defendant] providing analysis in support of [the Defendant's] independence determination despite [the Defendant] having provided advice to [one of the co-founders of the operating company] and his affiliates.Id. ¶ 83. The basis for the allegation that the Defendant "provid[ed]" such "advice" is apparently the preceding paragraph of the complaint, in which it is alleged the Defendant "did not dispute that [it] provided services and advice to [one of the operating company's co-founders] and his affiliates." Id. ¶ 82.
This could perhaps provide additional support for an inference of scienter. But it does not need to be addressed now, because the Plaintiffs' allegations do not hang together.
Take first the allegation that, after the merger, the public company "stated" it did not receive "written . . . analysis in support of [the Defendant's] independence determination." Id. ¶ 83. But that allegation is all there is. No context is provided. Nothing about when this alleged statement was made, for example, or to whom, or what the response was. This is too little to go on. Cf. In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999) (plaintiffs asserting securities fraud claims must specify "the who, what, when, where, and how: the first paragraph of any newspaper story") (cleaned up).
Now take the allegation the Defendant "did not dispute that [it] provided services and advice to [one of the operating company's co-founders] and his affiliates." Complaint ¶ 82.
Context makes clear, see id., that this is a reference to the February 2022 back-and-forth described above, in Part III.B.1. Recall that in the February 2022 correspondence, the Defendant "dispute[d]," Complaint ¶ 82, some things, including that it helped to "create and structure" the November and December stock sales. See Complaint ¶ 79. And recall that in the February 2022 correspondence the Defendant did not "dispute" some other things, including that it was aware of the stock sales, and that these were "discussed." See id.
But there is simply no third category in the February 2022 letter, of "provid[ing] services and advice to [one of the operating company's co-founders] and his affiliates." Complaint ¶ 82. That assertion was not "dispute[d]" by the Defendant because it was not made in the first place.
Bottom line: the Plaintiffs' allegation that the Defendant "did not dispute that [it] provided services and advice to [one of the operating company's co-founders] and his affiliates," is not really an allegation, or a reasonable inference from other allegations. It is, rather, a dressed-up argument about the February 2022 correspondence --- and an argument that misinterprets that correspondence by reading something into it that is not there. It must be put aside. See Connelly, 809 F.3d at 787; cf. Drucker Cornell v. Assicurazioni Generali S.p.A. Consol., 2000 WL 284222, at *2 (S.D.N.Y. Mar. 16, 2000) ("legal conclusions done up as factual allegations are not facts and cannot substitute for facts.").
6. Conclusion
As noted above, to decide if scienter is adequately plead, the Court first "determine[s] whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard." Martin, 757 F. App'x at 154 (emphasis in original, cleaned up).
To make that "collective" task more manageable, the Court has focused until now on the individual components of the alleged scienter here, in Parts III.B.1 through III.B.5 above. The Court now adds them up --- and concludes that, together, they establish a "strong inference" of scienter.
The two red flags here were big and bright. See Part III.B.1 and III.B.2. Big --- because together they suggested that the financial statements audited by the Defendant were potentially erroneous, and by a very large amount. And bright --- because they were plainly visible to the Defendant, because it was aware of the two 2020 stock sales. In spite of these red flags, the Defendant "forged ahead," AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202, 221 (2d Cir. 2000), and issued the clean opinion.
Moreover, the red flags were, together, more than the sum of their parts. An on-its-face low share valuation made the lack of valuation more worrisome. And the lack of valuation did the same for the low share valuation.
In addition, the broader context magnified the importance of the red flags. See Part III.B.3. As to the November 2020 stock sale, the allegation is not just that the shares that were issued were too cheap and not-really-valued. It is also that they were issued for the benefit of the senior-most leaders of the company. This suggested a motive for these leaders to, at a minimum, cut corners to benefit themselves. And it suggested an opportunity for them to do so --- and all the more so against the backdrop of a company that had been founded three months before the November 2020 stock sale, and that did not have an especially experienced senior team.
This case involves fewer red flags than some others. But "inference is not arithmetic." Institutional Invs. Grp., 564 F.3d at 273. The substance of the red flags at issue, plus the overall context in which they are raised, makes them loom especially large.
So too the alleged GAAP violations. See Part III.B.4. They are simple. They are based on information the Defendant was aware of before it issued its clean opinion. And they are, as alleged, very large --- involving, for example, an understatement of operating expenses of more than 9000%, based on a jump in such expenses from $7 million to $700 million. See Complaint ¶ 65 (chart).
All of the above adds up to a strong inference of scienter, alleged in a matter that meets the relevant standards of particularity and plausibility. "[A]ccepting the whole factual picture painted by the Complaint," the Court concludes that the strong inference is that the Defendant was "at least reckless, which is enough to survive a motion to dismiss[.]" Institutional Invs. Grp., 564 F.3d at 269.
C. Other Inferences
The conclusion set out above tees up the final part of the scienter analysis, "tak[ing] into account plausible opposing inferences." Martin, 757 F. App'x at 154 (cleaned up). As to this part of the analysis, the Court
must consider plausible, nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff. An inference that a defendant acted with scienter need not be irrefutable. However, it must be more than merely reasonable or permissible --- it must be cogent and compelling.Id. (cleaned up). A securities fraud complaint can survive a motion to dismiss on scienter grounds only if "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged." Id. (cleaned up); see generally Tellabs, 551 U.S. at 326, 127 S.Ct. 2499; Institutional Invs. Grp., 564 F.3d at 252-53.
Here, there are a few "plausible, nonculpable explanations" for the Defendant's issuance of the clean opinion.
One: the Defendant was intentionally kept in the dark by management, or even lied to. This happens to auditors, and one could construct an argument that it happened here.
After all, the senior-most leaders of the operating company allegedly engaged in plenty of worrying conduct, as described throughout the complaint. And during 2022 they were subjected to "severe" punishment in connection with the 2020 stock sales, in circumstances that suggest, the Plaintiffs assert, that their conduct was "intentional." See Complaint ¶¶ 69-70. Moreover, the operating company leaders were allegedly not fully honest or accurate in 2022, when an investigation was mounted into their conduct, see id. ¶ 70, and that investigation surely included the 2020 stock sales.
Maybe the operating company leaders hid the ball from their auditors, and did not tell them about the 2020 stock sales?
This argument "c[an] [be] draw[n] from the facts alleged." Martin, 757 F. App'x at 154. But it is not remotely as plausible or as convincing as the inference, described above in Part III.B.1., and based largely on the February 2022 correspondence, that the Defendant was affirmatively aware of the 2020 stock sales before it issued its clean opinion. The inference from the 2022 correspondence is strong. It is direct. It is based on a written exchange. And it is supported by various other allegations --- including the allegation that the much larger 2020 stock sale (the November sale) was made public during 2021. Publicizing a stock sale is at odds with lying to hide it.
Another possible "nonculpable" explanation: the company was new, and much of the senior team was inexperienced, see Part III.B.3 --- and so they did not grasp the potential problem with the 2020 stock sale, and, accordingly, did not bring the relevant issue to the Defendant.
But so what? Some members of management may not have understood the import of the stock sales well enough to clang the bell and involve the auditors. But in the end, that did not matter. Because, as set out above, the Defendant was aware of the 2020 stock sales. Management may not have been experienced enough to reliably issue spot. But here that did not matter --- one way or another, the issue got before the Defendant.
A final possible argument: the Defendant was not reckless, it was just negligent; it was a bit sloppy, and made a mistake.
But this, too, is greatly less "plausible" than the alternative. The red flags were much too big and much too plain-to-see. Moreover, context amplified the red flags, by bringing to the fore concerns about self-dealing by more-experienced company leaders at the expense of the company as a whole. And the Defendant's own "going public" guidance heightened these concerns. Finally, the GAAP errors here, as alleged, were well beyond material. An alleged 9000% miss in estimating operating expenses is hard to square with negligence.
In short: the strong inference of scienter, on a recklessness theory, is compelling and cogent, and it is markedly more compelling than any alternative that can be drawn from the complaint.
* * *
The Defendant has moved to dismiss on various grounds, including that it lacked scienter. For the reasons set out above, that argument is not persuasive. IV. Misrepresentation of "Fact"
As noted above, in addition to pressing arguments from scienter, the Defendant also contends that "Plaintiffs have not alleged a misstatement under Edinburgh." Defendant's Memo at 14 (cleaned up). Edinburgh is a 2014 Court of Appeals case, City of Edinburgh Council v. Pfizer, Inc., 754 F.3d 159 (3d Cir. 2014), that, the Defendant argues, establishes a framework in this Circuit for analyzing possible liability under Rule 10b-5 for opinions --- as the Defendant contends its clean opinion was.
But as the Defendant noted, as of the time its opening brief was filed, the Court of Appeals had "on three occasions declined to determine" whether a 2015 Supreme Court case (Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 575 U.S. 175, 183, 135 S.Ct. 1318, 191 L.Ed.2d 253 (2015)) might apply to Rule 10b-5 cases such as this one. Omnicare is about allegedly false opinions, and if it did govern in the Rule 10b-5 context, the Edinburgh framework might potentially be altered or displaced.
The Court of Appeals has now decided that Omnicare and its three-part framework does indeed apply in Rule 10b-5 "opinions" cases. See City of Warren Police & Fire Ret. Sys., 70 F.4th at 684. But it did so after both the Defendant and the Plaintiffs filed their opening briefs. Therefore, the parties' main briefs do not meaningfully reckon with Omnicare.
Omnicare might potentially alter the way one thinks about the remaining issue raised by the Defendant's motion to dismiss --- whether the Plaintiffs adequately pled a misstatement of material "fact" with respect to their allegations about the clean opinion. The parties should have the chance to present their views on this point. An order will issue today, setting a briefing schedule to give the parties an opportunity to do so.
* * *
The Defendant's motion to dismiss is denied to the extent it presses scienter arguments.
The Defendant's motion to dismiss is held in abeyance to the extent it presses arguments as to its misstatements of "fact," so the parties can brief the impact, if any, of a newly-decided Third Circuit Court of Appeals case on this point.