United States District Court, S.D. New York
July 5, 2005.
FRATERNITY FUND LTD., et al., Plaintiffs,
BEACON HILL ASSET MANAGEMENT LLC, et al., Defendants.
The opinion of the court was delivered by: LEWIS KAPLAN, District Judge
The case is before the Court on the motions by defendants Ernst
& Young LLP ("E&Y LLP") and Ernst & Young Cayman Islands ("E&Y
Cayman Islands") (collectively the "E&Y Defendants") to dismiss
the amended complaint ("Complaint").
As the Complaint is described in an opinion issued today (the
"Opinion"), only a brief summary of the allegations is
necessary.*fn1 At the center of this action is an alleged
valuation fraud involving three hedge funds ("Funds"). Cpt. ¶¶
1-5. From March 2000 through September 2002, the Funds' managers
allegedly misrepresented in offering memoranda, audited financial
statements, and other settings that the Funds' net asset values
("NAVs") would be calculated in good faith using independent
prices. Id. ¶¶ 42-50. Contrary to those representations, they
allegedly overpriced the Funds' portfolios for purposes of
reporting NAVs in audited financial statements and month-end
reports. Id. ¶¶ 56, 103. The E&Y Defendants allegedly are
liable for valuations in the audited financial statements on the
ground that they "knew and ignored or recklessly failed to obtain
or learn the facts which indicated that the Funds' audited
financial statements were materially false and misleading and
violated" various accounting rules. Id. ¶ 87.
Twenty-nine of the 36 plaintiffs bring claims against E&Y
Cayman Islands for violations of Section 10(b) of the Securities
and Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78a et
seq., and Rule 10b-5 thereunder, 17 C.F.R. § 240.10b-5, and on
state law theories. See Cpt. claims 15-19. Plaintiffs Balentine Global Hedge Fund, L.P. and
Balentine Global Hedge Fund Select, L.P. assert the same claims,
but against E&Y LLP. See Cpt. claims 28-32.
The E&Y Defendants move to dismiss on various grounds,
including, primarily, that the Complaint fails to satisfy
Fed.R.Civ.P. 9(b) and/or the Private Securities Litigation Reform Act
("PSLRA"), 15 U.S.C. § 78u-4(b).
Plaintiffs take issue with the Funds' audited financial
statements for various reporting periods ending between March
2000 and March 2002. Cpt. ¶ 103. They allege on information and
belief that these financial statements materially overstated the
Funds' NAVs. However, for the reasons explained in the Opinion,
plaintiffs fail to allege facts sufficient to justify an
inference that NAVs reported prior to April 2002 were false and
misleading. As all of audited financial statements at issue in
this case were dated prior to April 2002, plaintiffs' securities
claims against the E&Y Defendants are dismissed for failure to
satisfy Rule 9(b) and the PSLRA.
Plaintiffs' securities claims fail for another reason as well.
They fail to "state with particularity facts giving rise to a
strong inference that the defendant[s] acted with the requisite
state of mind." 15 U.S.C. § 78u-4(b)(2). This may be done "either
(a) by alleging facts that defendants had both motive and
opportunity to commit fraud, or (b) by alleging facts that
constitute strong circumstantial evidence of conscious
misbehavior or recklessness." Acito v. IMCERA Group,
47 F.3d 47, 52 (2d Cir. 1995). Plaintiffs rely solely upon the latter
test and make three allegations. See Pls. Mem. at 11-22.
First, they allege that Beacon Hill Asset Management's prime
broker, Bear Stearns, independently valued the securities in the
Funds' portfolios; that valuations based on Bear Stearns prices
resulted in portfolio valuations that were lower than the
valuations published by the Beacon Hill Defendants; that the
valuation disparity was 10 to 15 percent in March 2000 and March
2001 and 16.32 percent in March 2002; that the E&Y Defendants
"must have received" the Bear Stearns valuations; and that the
disparity "should have caused E&Y Cayman and E&Y LLP to challenge
the appropriateness of such internal values and caused
substantial doubt as to the fairness of the internal values."
Cpt. ¶ 102.
As an initial matter, plaintiffs fail to allege the basis for
their belief that the E&Y Defendants had access to Bear Stearns'
valuations. See Cpt. ¶ 98. But even assuming arguendo that
the auditors did possess those valuations, plaintiffs have not
alleged with particularity that the disparity created a red flag.
As explained in the Opinion, the Funds "involved non-exchange
listed securities, the valuation of which may differ depending on
the model used in the calculations. In other words, valuation of
such securities was not a matter of looking up closing prices in
the Wall Street Journal, but involved the exercise of
judgment." Opinion Section III(A) (internal citation and
quotation marks omitted). Plaintiffs do not allege that the
models used or the judgments made by Bear Stearns were superior to those used or made by Beacon Hill,
nor do they allege that the differences in valuations were
outside the range of what was considered normal in the industry.
Accordingly, they fail to allege that any Bear Stearns/Beacon
Hill valuation disparity created a red flag.
Second, plaintiffs argue that the E&Y Defendants violated
certain accounting rules by failing "to independently corroborate
the internal fair valuations reported in the financial statements
created by" the Funds' managers. Cpt. ¶ 12. But the Complaint
fails to allege facts sufficient to justify their assertion that
the E&Y Defendants did not independently corroborate the
valuations by the Funds' managers.
Finally, plaintiffs argue that the "magnitude of the fraud"
supports an inference of scienter on the part of the E&Y
Defendants. Pls. Mem. at 21. They argue that the "fraud spanned a
period of at least two years" and that the Bear Stearns' marks
were between 10 to 16.32 percent lower than the Beacon Hill
marks. These allegations fail for the reasons noted above.
Plaintiffs do not allege facts sufficient to justify their
assertion that the Bear Stearns/Beacon Hill valuation disparity
created a red flag. Accordingly, plaintiffs fail to allege
scienter on the part of the E&Y Defendants.
C. State Law Claims
Plaintiffs allege various state law claims against the E&Y
Defendants. However, for the reasons addressed in the Opinion,
the Court lacks supplemental jurisdiction over those claims.
See Opinion Section V n. 128.
As the Complaint fails to satisfy either the PSLRA or Rule 9(b)
as to the moving defendants, the Court does not address
defendants' remaining arguments for dismissal of the federal
securities law claims. The motions of defendants E&Y LLP and E&Y
Cayman Islands to dismiss the federal securities law claims
[docket items 63 and 66, respectively] are granted. As there is
no independent basis of federal jurisdiction over the state law
claims, they are dismissed as well.