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FRATERNITY FUND LTD. v. BEACON HILL ASSET MANAGEMENT LLC

United States District Court, S.D. New York


July 5, 2005.

FRATERNITY FUND LTD., et al., Plaintiffs,
v.
BEACON HILL ASSET MANAGEMENT LLC, et al., Defendants.

The opinion of the court was delivered by: LEWIS KAPLAN, District Judge

ORDER

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).

  A. Falsity

  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.

  B. Scienter

  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.

  D. Conclusion

  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.

  SO ORDERED.


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