The opinion of the court was delivered by: Arthur D. Spatt, United States District Judge.
MEMORANDUM OF DECISION AND ORDER
The plaintiff HSA Residential Mortgage Services of Texas ("HSA" or the "plaintiff") brings this action against the defendants Joseph Casuccio ("Casuccio"), Jeffrey J. Schneider ("Schneider"), Aaron Chaitovsky ("Chaitovsky"), Robert Glass ("Glass"), Werblin, Casuccio & Moses, P.C. (the "Werblin Firm") and Citrin Cooperman & Co., LLP (the "Citrin Firm") alleging that they prepared and approved financial statements that were intended to cover up fraudulent schemes perpetrated by AppOnline.com, Inc ("AOP") and its subsidiary, Island Mortgage Network, Inc. ("Island") in violation of common law negligence and fraud. Presently before the Court are two motions to dismiss the complaint pursuant to Rules 12(b)(6) and 9(b) of the Federal Rules of Civil Procedure, one by the Werblin Firm and Casuccio and another by the Citrin Firm, Chaitovsky and Glass.
The facts are taken from the complaint unless otherwise noted. HSA is incorporated and has its principal place of business in Texas. HSA is a purchaser for resale of residential real estate mortgage loans that it does not originate. The Werblin Firm is a partnership residing in Suffolk County, New York and is engaged in accounting and auditing. Casuccio is a resident of New York and a member of the Werblin Firm. Schneider is a resident of New York and was employed at the Werblin Firm. The Citrin Firm is a partnership residing in New York and is engaged in accounting and auditing. Chaitovsky and Glass are residents of New York and members of the Citrin Firm.
AOP is labeled a relevant non-party in the complaint. AOP is a Delaware corporation that had its principal place of business in New York. From 1997 to June 2000, AOP was a mortgage company. Between May 1997 to April 1999, AOP was known as IMN Financial, Inc. and operated under the trade name Island. Beginning in May 1997, AOP was quoted on the NASD's Over-the-Counter Electronic Bulletin Board. In September 1999, AOP began trading on the American Stock Exchange. On July 19, 2000, AOP filed for bankruptcy and ceased operations.
AOP, through its subsidiary Island, provided mortgage loans to prospective homeowners. To fund these loans, "warehouse funders" such as HSA advanced monies to AOP under mortgage purchase agreements. After the closing of a mortgage loan, AOP sold the loan to financial institutions on the secondary mortgage market and used the proceeds from those sales to repay the warehouse funders. AOP's revenues consisted primarily of the points and other fees that borrowers paid in connection with obtaining the mortgage loan.
In 1997, AOP's common stock began trading publicly. At that time, AOP's senior management consisted of Paul Skulsky, Jeffrey Skulsky and Edward Capuano ("Capuano"). Paul Skulsky was responsible for coordination of the financing for AOP's operations and acquisitions; Jeffrey Skulsky was responsible for day-to-day management of AOP's administrative operations; Capuano was responsible for AOP's relationships with warehouse funders and supervision of its sales offices. Jeffrey Skulsky and Capuano were named officers of AOP. Paul Skulsky never received a formal title at AOP because he wanted to conceal the fact that he was a convicted felon and was acting as one of AOP's senior officers and directors.
In 1997, AOP expanded its operations through various acquisitions. During this time, AOP began losing money because the mortgage fees generated from those acquisitions did not cover its increased operating expenses. AOP covered its increased operating expenses by using the money that HSA and other warehouse funders provided for specific mortgage loans. Over time, this practice evolved into a "Ponzi Scheme". For example, AOP used later funds received from warehouse funders-designated to fund specific mortgage loans-to fund earlier mortgage loans. AOP also used any available funds to repay the warehouse funders, including funds that were provided for other mortgage loans, when a specific mortgage loan did not close and funds had to be returned to a warehouse funder.
2. The False Financial Statements
a. AOP's December 31, 1997 Financial Statements
In its internal and financial books, AOP recorded the amount wrongfully diverted from mortgage loan funds as a liability to certain escrow agents involved in the transfer of the mortgage loan funds, when AOP, in fact, owed the diverted funds to the warehouse funders. In its financial statements, AOP also disguised its growing liability to the warehouse funders by creating a "phantom" payable to The Skulsky Trust, which was a related party controlled by Paul Skulsky and Jeffrey Skulsky. To reduce the amount "supposedly" owed to The Skulsky Trust, AOP then offset certain debts "supposedly" owed to AOP by other related parties controlled by Paul Skulsky and Jeffrey Skulsky against AOP's liability to The Skulsky Trust. In addition, AOP violated Generally Accepted Accounting Principles ("GAAP") by offsetting the "supposed" receivables from other related parties against The Skulsky Trust payable.
On March 31, 1998, AOP filed a Form 10-KSB for the fiscal year ended December 31, 1997 which included AOP's 1997 financial statements (the "1997 Annual Report"). The Werblin Firm and Casuccio prepared, reviewed and approved the 1997 Annual Report which was allegedly in violation of GAAP and Generally Accepted Accounting Standards ("GAAS"). The 1997 Annual Report was allegedly false and misleading because it: (1) failed to disclose Paul Skulsky's management role at AOP; (2) failed to disclose that AOP had incurred a liability of at least $4,900,000 to warehouse funders and instead falsely reported that AOP owed approximately $4,900,000 to The Skulsky Trust; and (3) understated AOP's operating loss by an additional $700,000 by ignoring certain commission expenses and overstating income from management fees.
The Werblin Firm and Casuccio audited and approved the 1997 Annual Report and financial statements. The Werblin Firm and Casuccio were allegedly grossly negligent for blindly accepting AOP management's portrayal of AOP's financial condition and by failing to pursue information that would have disclosed the improprieties. The Werblin Firm and Casuccio allegedly knew that the warehouse funders, including HSA, would rely on the 1997 Annual Report and financial statements for that year.
b. AOP's December 31, 1998 Financial Statements
During 1998, AOP's operations continued to lose money. Because AOP had diverted funds designated for specific mortgage loans to pay its operating expenses in 1997, AOP had to replace these funds so that those mortgage loans could close. To replace the diverted funds, AOP misappropriated even more funds from HSA and the warehouse funders. To conceal the increased debt owed to HSA and other warehouse funders, AOP continued to: (a) report falsely that it owed that debt to The Skulsky Trust; and (b) offset wrongfully receivables from other related parties against AOP's phony debt to The Skulsky Trust.
In addition to the fraud concerning its debt to the warehouse funders, Paul Skulsky, Capuano, Casuccio and the Werblin Firm artificially removed several money-losing subsidiaries from AOP's financial reports. For example, in March 1998 and October 1998, AOP entered into two phony sale transactions with Northport Industries, Inc. ("Northport"), a shell company controlled by Paul Skulsky. Through these transactions, AOP appeared to have sold certain subsidiaries to Northport but AOP continued to manage the subsidiaries. Northport executed a note payable to AOP for the subsidiaries and also agreed to pay AOP a management fee of $50,000 per month. As a result of these paper transactions, AOP avoided recognizing approximately $2,400,000 in losses sustained by the subsidiaries. The defendants allegedly knew or should have known that the Northport transactions were not arms-length transactions and that they served no business purpose except to enable AOP to avoid reporting the losses incurred by its subsidiaries.
On April 15, 1999, AOP filed an amended Form 10-KSB for the year ended December 31, 1998 (the "1998 Amended Annual Report"). The Werblin Firm, Casuccio and Schneider prepared, reviewed and approved the 1998 Amended Annual Report, which allegedly violated GAAP and GAAS. The 1998 Amended Annual Report was allegedly false and misleading because it: (1) failed to disclose the management role of Paul Skulsky; (2) failed to disclose that AOP owed at least $10,400,000 to the warehouse funders and instead stated falsely that AOP owed approximately $10,400,000 to The Skulsky Trust; (3) failed to report at least $2,400,000 in 1998 operating losses attributable to the subsidiaries that were the subject of the phony sales to Northport; and (4) inflated revenues and under-reported other expenses by approximately $735,000. AOP allegedly should have reported an operating loss of at least $3,200,000, instead of the $787,297 operating income that it reported.
The Werblin Firm, Casuccio and Schneider audited and approved the 1998 Amended Annual Report and financial statements. The Werblin Firm, Casuccio and Schneider were allegedly grossly negligent by blindly accepting AOP management's portrayal of AOP's financial condition and by failing to pursue information that would have disclosed the improprieties. The Werblin Firm, Casuccio and Schneider allegedly knew that the warehouse funders, including HSA, would rely on the 1998 Amended Annual Report and the financial statements for that year.
c. AOP's December 31, 1999 Financial Statements
By December 31, 1999, AOP had misappropriated approximately $47,000,000 from its warehouse funders. By the end of 1999, Paul Skulsky, Jeffrey Skulsky and Capuano decided to remove AOP's phony liability to The Skulsky Trust from AOP's balance sheet without recognizing any liability to the warehouse funders. To achieve this objective, AOP issued 18,191,534 shares of its stock to The Skulsky Trust in exchange for extinguishing the debt AOP purportedly owed to The Skulsky Trust.
In December 1999, the Werblin Firm withdrew from its role as AOP's independent auditor. At Schneider's suggestion, AOP engaged the Citrin Firm as auditor of its 1999 financial statements. Schneider assisted the Citrin Firm by preparing the work papers for the audit and assisting the Citrin Firm to file the 1999 financial statements in a timely fashion. Schneider allegedly knew that the financial statements that he helped the Citrin Firm prepare contained false statements of material fact, including overstated mortgage inventory, understated operating losses and misrepresentations relating to losses attributable to the start-up of Island's proposed Internet spin-off division.
On April 14, 2000, AOP filed a Form 10-K for the year ended December 31, 1999 (the "1999 Annual Report"), which included AOP's financial statements. The 1999 Annual Report was false and misleading because it: (1) failed to disclose the management role of Paul Skulsky; (2) omitted $47,000,000 liability to the warehouse funders while stating that the previous purported debt to The Skulsky Trust had been exchanged for AOP equity securities; and (3) understated expenses and overstated revenues by approximately $1,500,000. Chaitovsky prepared, reviewed and audited the 1999 Annual Report. Glass and the Citrin Firm reviewed and approved the 1999 Annual Report.
The Citrin Firm, Chaitovsky and Glass audited and approved the 1999 Annual Report and financial statements for that year. The Citrin Firm, Chaitovsky and Glass were allegedly grossly negligent for blindly accepting AOP management's portrayal of AOP's financial condition and by failing to pursue information that would have disclosed the improprieties. The Citrin Firm, Chaitovsky and Glass allegedly knew that the warehouse funders, including HSA, would rely on the 1999 Annual Report and financial statements for that year.
Before completing their audit of the 1999 financial statements, the Citrin Firm, Chaitovsky and Glass learned that AOP had filed prior false financial statements with the United States Securities and Exchange Commission (the "SEC"). In particular, AOP's financial statements contained in the Form 10-QSB for the period ended September 30, 1999 were materially false in that they failed to include losses associated with AOP's Internet division. After learning of this false statement, the Citrin Firm, Chaitovsky and Glass failed to inform the appropriate AOP management personnel and make sure that AOP's audit committee was adequately informed of this false statement. The Citrin Firm, Chaitovsky and Glass also allegedly failed to notify the SEC or any other regulatory body about this false statement.
d. Other False and Misleading Public Financial Statements
On December 29, 1999, AOP filed a Form S-1 which was materially misleading because it reported the false payable to The Skulsky Trust. In particular, the Form S-1 falsely stated that approximately $15,900,000 was owed to The Skulsky Trust as of September 30, 1999 when in fact substantially more funds were owed to the warehouse funders at that time. Casuccio, Schneider and the Werblin Firm prepared, audited, reviewed and approved the false and misleading 1997 and 1998 financial statements which were incorporated in AOP's public filings.
3. The Related Criminal Proceedings
On October 23, 2001, Casuccio pleaded guilty to securities fraud conspiracy in connection with the allegation that he along with others knowingly prepared materially false and misleading financial statement which were provided to "warehouse" lenders and issued audit opinions that falsely represented that AOP's financial statement had been prepared in conformity with GAAP and had been conduct in accordance with GAAS. See United States v. Casuccio, No. 01-1098 (DRH) (E.D.N.Y. Oct. 23, 2001). On October ...