When Kidder discovered the scheme, it informed GE and fired the
broker. See id. GE in turn reshuffled top management at Kidder
and conducted an internal investigation. See id. The complaints
against GE alleged that the company had knowingly or recklessly
recorded as profitable transactions that were fictitious. See
id. at 266. In affirming the district court's dismissal of the
claims against GE, the Second Circuit reasoned that GE was not
reckless not to have assumed that the record profits of the bond
traders indicated that a fraudulent scheme was afoot. See id.
The Insider Defendants are not alleged here to have failed
simply to recognize the "red flags" indicating fraudulent
activity; Drabinsky and Gottlieb are alleged to have orchestrated
the fraud in general and to have personally carried out many of
its specifies. Topol and Messina are alleged to have participated
in carrying it out with knowledge of its impropriety. The
positions of Drabinsky, Gottlieb, Topol, and Messina here are
analogous to that of the bond trader in Chill, not to that of
GE. See also In re Health Management, 970 F. Supp. at 204.
Finally, the Insider Defendants, relying on Novak v. Kasaks,
26 F. Supp.2d 658, 660 (S.D.N.Y. 1998), maintain that Plaintiffs
have failed to allege adequately the sources of information in
the Complaint. This claim is baseless. "The Second Circuit . . .
has held that `[d]espite the generally rigid requirement that
fraud be pleaded with particularity, allegations may be based on
information and belief when facts are peculiarly within the
opposing party's knowledge. . . .'" Vento & Co. of New York. LLC
v. Metromedia Fiber Network, Inc., 1999 WL 147732, No. 97 Civ.
7751(JGK), 1999 WL 147732, at *7 (quoting Wexner v. First
Manhattan Co., 902 F.2d 169, 172 (2d Cir. 1990); see also In re
Health Management Systems, Inc. Securities Litigation, 97 Civ.
1865, 1998 WL 283286, at *3 (S.D.N.Y. June 1, 1998)). It is also
apparent that much of the Complaint is culled from Livent's SEC
filings and the SEC complaint in the separate civil action
against several of the Individual Defendants. These sources, and
others, are acknowledged in Paragraph 211 of the Complaint, which
sufficiently alleges Plaintiffs' sources of information.
For these reasons, the motions to dismiss of Defendants
Drabinsky, Gottlieb, Topol, and Messina are denied.
2. D & T's Motion To Dismiss Is Granted
D & T moves to dismiss for failure to plead scienter and to
plead fraud with particularity.
a. Scienter Is Not Adequately Pled
Plaintiffs do not contest D & T's claim that the Complaint does
not allege motive and opportunity on the part of D & T. On the
basis of settled law in this Circuit, see, e.g., Chill, 101
F.3d at 268; Aquino v. Trupin, 833 F. Supp. 336, 341 (S.D.N Y
1993), this Court independently agrees. Thus, the only issue is
whether Plaintiffs have alleged circumstantial evidence of
conscious misbehavior or recklessness.
Plaintiffs claim to have pled specific factual allegations
permitting the inference that D & T was aware of the fraudulent
scheme, or at best reckless in ignoring the indicators of fraud.
These allegations are: (1) the magnitude of the restatement; (2)
the economic irrationality of the five fraudulent revenue
generating transactions; (3) the "obvious" paper trail left by
the transfer of incurred expenses from closed shows to ongoing
shows. Actions taken by the Insider Defendants to hide other,
independent forms of fraud do not, Plaintiffs claim, diminish D &
T's liability on the basis of these allegations.
(1) The Magnitude of the Fraud
"[W]hen tidal waves of accounting fraud are alleged, it may be
determined that the accountant's failure to discover his client's
fraud raises an inference
of scienter on the face of the pleading." Leslie Fay, 835
F. Supp. at 175. On this basis alone, Plaintiffs maintain they
have met the pleading burden for scienter. Defendants maintain,
on the contrary, that the magnitude of the fraud by itself cannot
suffice; it must be accompanied by other factors. See, e.g., In
re Health Management, 970 F. Supp. at 203 (magnitude of fraud,
coupled with other factors, sufficient to allege scienter against
outside auditor). There is no controlling authority on the
question in this Circuit, and a paucity of decisions elsewhere.
See, e.g., DiLeo v. Ernst & Young, 901 F.2d 624, 626 (7th Cir.
1990); Reiger v. Altris Software, Inc., No. 98-CV-528, 1999 WL
540893, at *8 (S.D.Cal. Apr. 30, 1999); Rehm v. Eagle Finance
Corp., 954 F. Supp. 1246, 1256 (N.D.Ill. 1997).
It does not seem reasonable to infer recklessness on the part
of an auditor solely from the magnitude of a fraud, particularly
where, as here, the Complaint and the SEC complaint describe in
detail how the magnitude of the fraud was accompanied by the
thoroughness of its concealment. On the other hand, it would be a
mistake to ignore the magnitude of the fraud entirely. Common
sense suggests that, all other things being equal, more
opportunities should exist to discover a larger fraud than a
smaller fraud, especially where, as here, the magnitude of the
fraud was not accomplished by one fraudulent transaction of
enormous monetary significance, but by countless small
adjustments to the accounting entries on the productions, several
sizable loans concealed as sales of production rights, and the
other manipulations described in the Complaint. Added together,
of course, these manipulations were allegedly significant enough
to cause the bankruptcy of the Company. Thus, the magnitude of
the alleged fraud will be considered in weighing whether the
Complaint meets the pleading standard for scienter.
Although the magnitude of the fraud alone cannot suffice to
impute the requisite inference of knowledge or recklessness to D
& T, it does raise questions regarding D & T's performance of its
audits during the relevant years. For example, if D & T was aware
that the Company's management information systems were capable of
manipulating the accounts without leaving a paper trail, and
failed, despite this awareness, to take steps to insure that such
manipulations were not being performed, this might constitute
recklessness sufficient to infer scienter.
(2) Certification of False Financial Statements Based on
Economically Irrational Transactions
Plaintiffs' next basis for alleging recklessness is D & T's
certification of false financial statements dependent on the
"economically irrational transactions." Plaintiffs allege that D
& T should have been suspicious of the transactions, because on
their face the transactions made no economic sense from the
standpoint of Pace, American Artists, Wood Gundy, Dundee, and
Dewlim. In addition, D & T is alleged to have been aware that the
Dundee transaction was with a related party, which was not
disclosed in the financial statements. Finally, D & T allegedly
should have been suspicious when it discovered the Put Agreement.
Failure to further investigate these transactions, according to
Plaintiffs, constitutes strong circumstantial evidence of
recklessness on the part of D & T.