The opinion of the court was delivered by: Katherine B. Forrest, District Judge:
USDC SDNY DOCUMENT ELECTRONICALLY FILED
Lead Plaintiffs Nancy George, Robert George, and Randall Whitman (collectively, "plaintiffs") bring this putative class action against China Automotive Systems, Inc. ("CAAS") and CAAS's former auditor, Schwartz Levitsky Feldman LLP ("SLF" and with CAAS, "defendants"),*fn1 alleging violations of Section 10(b) of the Securities Exchange Act of 1934 ("section 10(b)"), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5 ("Rule 10b-5"). Plaintiffs' claims are predicated upon allegedly false or misleading misstatements in CAAS' filings with the Securities and Exchange Commission ("SEC") regarding, inter alia, CAAS' accounting for certain convertible notes issued February 15, 2008 (the "Convertible Notes"), CAAS' operating expenses and other charges against income, SLF's audit of CAAS' financial statements regarding the accounting for the Convertible Notes, SLF's lack of a license to conduct audits in the People's Republic of China ("PRC"), and CAAS' internal controls.
CAAS and SLF have moved to dismiss the Amended Complaint--CAAS on March 22, 2012, and SLF on April 27, 2012. The former motion was fully submitted as of April 18, 2012; the latter, as of May 24, 2012.
Only July 6, 2012, plaintiffs separately moved for appointment of Pomerantz Haudek Grossman & Gross LLP ("PHGG") as co-lead counsel. CAAS filed an opposition to the motion on July 23, 2012 (in which SLF joins); that motion was fully submitted as of August 2, 2012.
For the reasons set forth below, CAAS' motion to dismiss is DENIED; SLF's motion to dismiss is GRANTED; and plaintiffs' motion for appointment of PHGG as co-lead counsel is GRANTED.
For purposes of ruling on the motion to dismiss, the Court accepts as true all well-pleaded allegations in the Amended Complaint and draws all reasonable inferences in plaintiffs' favor. See Levy v. Southbrook Int'l Invs., Ltd., 263 F.3d 10, 14 (2d Cir. 2001). The Court also considers CAAS' SEC filings referenced in the Amended Complaint, see Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322 (2007); ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 (2d Cir. 2007), as well as other documents of which it may take judicial notice, such as certain 10b5-1 trading plans, see, e.g., Glaser v. The9, Ltd., 772 F. Supp. 2d 573, 593 n.14.
Plaintiffs are purchasers of CAAS securities, who bought those securities sometime between May 12, 2009, and March 17, 2011 (the "Class Period"). (Am. Compl. (Dkt. No. 24) ¶¶ 1, 13.)
CAAS, a Delaware corporation headquartered in the PRC, manufactures and sells power steering components and systems for automobiles. (Id. ¶ 14.) CAAS stock trades on the NASDAQ. (Id. ¶ 15.) It is alleged that in 2003, CAAS entered the U.S. market through a "reverse merger"--i.e., a process by which "a private operating company based in the PRC is 'acquired' by a previously registered U.S.-based publicly traded 'shell company,' thereby bypassing the rigorous IPO process." (Id. ¶¶ 5, 26.)
As discussed in note 1 supra, plaintiffs also name various officers and directors of CAAS. Hanlin Chen is alleged to have been CAAS' Chairman and a member of its board of directors during the relevant time period. (Am. Compl. ¶ 18.) Xi Liping is alleged to be Chen's wife. (Id. ¶ 19.) It is alleged that collectively, Chen and Liping sold nearly $10 million in CAAS' shares during the Class Period. (Id. ¶¶ 18-19.) Qizhou Wu was CAAS' CEO, President, and a member of the board of directors. (Id. ¶ 20.) Wu allegedly sold more than $13.4 million in CAAS' shares during the Class Period. (Id.) Wong Tse Yiu, Wang Shaobo, and Yu Shengbin are alleged to have been CAAS senior vice presidents during the relevant time period, who, collectively, sold nearly $20 million in CAAS' shares during the Class Period--Yiu sold over $7.6 million; Shaobo sold $5.6 million, and Shengbin sold $5.2 million. (Id. ¶¶ 21-23.) Chen, Liping, Wu, Yiu, Shaobo, and Shengbin are collectively referred to as the "Individual Defendants." As set forth in note 1 supra, they are not before the Court because they have not been served. Allegations relating to their stock sales are discussed only to provide context to the allegations of fraud against CAAS.
Defendant SLF, an accounting firm based in Toronto, Canada, audited CAAS' financial statements during the Class Period. (Id. ¶ 16.) SLF resigned from that position in December 2011. (Id.) It is alleged that SLF audited a number of "Chinese reverse merger companies," but was not licensed to conduct audits in the PRC. (Id. ¶¶ 2, 6.)
B. The Purportedly Fraudulent Misstatements and Omissions Plaintiffs posit five reasons as to why CAAS' annual and quarterly reports throughout the Class Period were false and misleading: (1) they repeatedly improperly acknowledged the importance of the accounting for the Convertible Notes, but then failed to apply the proper accounting principle; (2) they failed to account for certain operating expenses and other charges against income; (3) they failed to reveal "material deficiencies in internal controls"; (4) they failed to disclose that the financial results were not prepared in accordance with Generally Accepted Accounting Principles ("GAAP"); and (5) they failed to disclose that SLF was not licensed to conduct audits in the PRC and thus, ultimately would have to resign as auditor. (Am. Compl. ¶¶ 2, 47.)
The primary focus of the Amended Complaint relates to the allegations regarding the allegedly improper accounting for the Convertible Notes. The Convertible Notes were issued on February 15, 2008, pursuant to a February 1, 2008, Securities Purchase Agreement (the "SPA"). China Auto. Sys., Inc. (Form 8-K) at 1 (Feb. 1, 2008) ("Feb. 1 8-K") (Decl. of Neil R. Marder ("Marder Decl.") (Dkt. No. 28) Ex. B); see also China Auto. Sys., Inc. (Form 8-K) at 1 (Feb. 15, 2008) (Marder Decl. Ex. C). The SPA provided for the issuance of $35 million in senior, unsecured notes to two institutional investors with an original
principle amount of $35 million and common stock warrants to purchase 1,317,865 shares of common stock at an exercise price of approximately $8.85. Feb. 1 8-K at 1 (Items 1.01, 2.03, 3.02).
Subsequent to the issuance of the Convertible Notes, CAAS disclosed the performance of the Convertible Notes in their Forms 10-K and 10-Q throughout the Class Period. (See, e.g., Am. Compl. ¶¶ 33, 35, 37, 29, 42, 44, 46.) The disclosures varied little among the SEC filings at issue in this action. (Compare Am. Compl. ¶ 33 with id. ¶¶ 35, 37.) The disclosures read, in pertinent part:
The Company has evaluated the convertible notes for terms and conditions that are not clearly and closely associated with the risks of the debt-type host instrument (see Note 12). Generally, such features require separation from the host contract and treatment as derivative financial instruments. Certain features, such as the conversion option, were found to be exempt. Other features, such as puts and redemption features were found to require bifurcation and recognition as derivative liabilities. These derivative liabilities are recognized initially at fair value, using forward cash-flow valuation techniques. As of February 15, 2008, the compound derivative value amounted to $1,703,962. This derivative will be adjusted to its estimated fair value at the completion of each reporting period until the debt arrangement is ultimately settled, converted or paid. As of March 31, 2009, the compound derivative value amounted to $3,065,422. The income from adjustment of fair value of compound derivative has been recorded in the income statement as gain or loss on change in fair value of derivative. (See note 12 and 24) See, e.g., China Auto. Sys., Inc. (Form 10-Q) (May 12, 2009) at 23 (for the period ended Mar. 31, 2009).
C. Disclosure of the Risk
On March 17, 2011, CAAS issued a press release in which it announced that it expected to restate its previously issued financial statements for fiscal year 2009 and the first three quarters of 2010 to reflect non-cash gains or losses related to the accounting treatment for the [Convertible Notes] based on the guidance outlined in Accounting Standard Codification (ASC) 815 ("ASC 815").
China Auto. Sys., Inc. (Form 8-K) (Mar. 17, 2011) at Ex. 99.1 (quoted in Am. Compl. ¶ 48). CAAS disclosed that its treatment of the Convertible Notes failed to account for "an embedded conversion feature that allows for an adjustment to the conversion price in the event that the Company issues equity securities at a price lower than the original conversion price." Id. According to CAAS, the accounting errors "did not result from any changes in the Company's internal accounting policies," or from "fraud or intentional misconduct." Id.
CAAS simultaneously disclosed that it would delay filing its annual 10-K for the 2010 fiscal year due to the "nature and timing of the review" of the restatement of the Convertible Notes. China Auto. Sys., Inc. (Form 12b-25) at Part III (Mar. 17, 2011).
Plaintiffs allege that on March 17, 2011, those disclosures caused CAAS' stock price dropped $1.42 per share (i.e., approximately 14 percent), to close at $8.81. (Am. Compl. ¶ 49.)
On March 18, 2011, CAAS disclosed that based upon its delay in filing a 10-K for the 2010 fiscal year, the NASDAQ had sent a letter stating that CAAS was not in compliance with listing requirements and providing CAAS until May 16, 2011 to submit a plan of compliance. China Auto. Sys., Inc. (Form 8-K) at Ex. 99.1 (Mar. 21, 2011) (quoted in full at Am. Compl. ¶ 50). On that announcement, CAAS' shares allegedly lost an additional $0.20 per share, closing at $8.61 on March 21, 2010. (Am. Compl. ¶ 51.)
Plaintiffs allege that subsequent to PWC's "engagement in December 2010, and especially after its announcement of the impending earnings restatement in March 2011" (discussed further below), CAAS' stock lost 50 percent of its value through the end of the Class Period. (Am. Compl. ¶ 55.)
Plaintiffs allege that in December 2010 Price Waterhouse Cooper's "Chinese affiliate" ("PWC") replaced SLF as CAAS' auditor. (Am. Compl. ¶¶ 6, 54.) PWC issued the restatement of CAAS' financial in June 2011. (Id. ¶ 7.) According to plaintiffs, "as soon as" PWC reviewed the financial statements prepared by SLF, it found that the financial statements did not properly take a charge against income for the cost of the Convertible Notes' conversion feature. (Id. ¶ 55.) It is also alleged, however, that PWC found additional "understatements of expenses." (Id.) That is, review of the financial statements for fiscal year 2009 revealed "accounting errors in accumulated depreciation, deferred tax assets and accrued payroll and its related cost." China Auto. Sys., Inc. (Form 10-K/A) at 3 (June 24, 2011) (amended for the fiscal year ended Dec. 31, 2009).
The accounting errors regarding the Convertible Notes as well as the alleged "understatement of expenses" "represented material weaknesses in the Company's internal controls over financial reporting as of December 31, 2008 and 2009." (Id.) Specifically, the restated 2009 10-K identified two material weaknesses in internal controls:
1. The Company did not have sufficient personnel with appropriate levels of accounting knowledge and experience to address complex U.S. GAAP accounting issues, and to prepare and review financial statements and related disclosures under U.S. GAAP. Specifically, the Company's controls did not operate effectively to ensure the appropriate and timely analysis of and accounting for unusual and non-routine transactions and certain financial statement accounts, including, but not limited to, accounting and disclosure for the convertible notes and accounting for deferred taxes.
2. The Company did not have formalized closing procedures and adequate period-end review procedures to ensure a) proper preparation of the period-end financial statement closing entries and b) consistency of Id. at 35.
E. SLF's Alleged Violations of GAAS
Plaintiffs allege that the deficiencies in CAAS' 2009 annual and quarterly financial statements resulted from SLF's violations of Generally Accepted Accounting Standards ("GAAS"). In particular, the Amended Complaint alleges that SLF violated GAAS' third general standard, requiring auditors to "exercise professional due care in the performance of the audit and the preparation of the report." AU § 150.02. (Am. Compl. ¶ 58.) According to plaintiffs, SLF "knew or should have known" about how to properly account for the conversion feature in the Convertible Notes based upon the Financial Accounting Standards Board ("FASB")'s issuance of EITF Issue No. 07-05 ("Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock") in June 2008 (effective for financial statements issued for fiscal years after December 15, 2008). (Am. Compl. ¶ 56.) See also China Auto. Sys., Inc. (Form 10-K) at 38 (for the fiscal year ended Dec. 31, 2008).*fn2
Plaintiffs allege that the issuance of a new standard on how to treat derivative instruments such as the Convertible Notes should have caused SLF to exercise the "highest degree of professional skepticism" in its 2009 audit. (Am. Compl. ¶ 59.) It is further alleged that the purported failure to properly account for the Convertible Notes demonstrates that SLF did not obtain the proper "audit evidence" to evaluate CAAS' financial statements. (Am. Compl. ¶¶ 62, 63 (citing AU §§ 326.02, 326.25, 411.03).
With regard to the alleged "understatement of expenses", plaintiffs allege that as to the former, SLF "simply 'rubber stamped' its opinion" on CAAS financial statements. (Am. Compl. ¶ 65.) As to the purported material weaknesses in CAAS' internal controls, the Amended Complaint alleges that "the severity of the material weaknesses disclosed" in CAAS' restated 2009 10-K demonstrates that SLF had not obtained "sufficient understanding of the Company's internal control[s]." (Id. ¶ 64.)
F. Insiders' Sales of Stock and the 10b5-1 Plans Plaintiffs allege that the Individual Defendants collectively sold over $40 million in CAAS shares during the Class Period in order to profit from the allegedly inflated value of CAAS stock. (Am. Compl. ¶¶ 17, 68.) Plaintiffs allege that Chen (CAAS' Chairman and a director) sold $596,745 worth of CAAS shares during the Class Period and that Liping--Chen's wife--made Class Period sales worth $9.3 million. (Id. ¶¶ 18-19.) Wu, CAAS' CEO, sold over $13 million in CAAS shares during the Class period, and the three senior vice ...