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In re Longtop Financial Technologies Ltd. Securities Litigation

United States District Court, S.D. New York

November 14, 2012

In re LONGTOP FINANCIAL TECHNOLOGIES LIMITED SECURITIES LITIGATION.

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Kimberly A. Justice, Esq., John A. Kehoe, Esq., John J. Gross, Esq., Kessler Topaz Meltzer & Check, LLP (PA), Radnor, PA, Daniel L. Berger, Esq., Jeff A. Almeida, Esq., Deborah A. Elman, Esq., Reena S. Liebling, Esq., Grant & Eisenhofer, P.A. (NY), New York, NY, for Plaintiffs.

Gary F. Bendinger, Esq., Gazeena K. Soni, Esq., Sidley Austin LLP, New York, NY, for Defendants.

OPINION AND ORDER

SHIRA A. SCHEINDLIN, District Judge.

I. INTRODUCTION

Lead plaintiffs Danske Invest Management A/S and Pension Funds of Local No. One (collectively, " Lead Plaintiffs" ) bring this action on behalf of themselves and others similarly situated against Longtop Financial Technologies, Ltd. (" Longtop" ), several of its officers, its auditor Deloitte Touche Tohmatsu CPA Ltd. (" DTTC" ), and its auditor's parent company Deloitte Touche Tohmatsu Limited. The Class consists of all persons and entities who purchased American Depositary Shares (" ADSs" ) of Longtop Financial Technologies, Ltd. on the New York Stock Exchange (" NYSE" ) during the period June 29, 2009 through and including May 17, 2011 (the " Class Period" ) and who were allegedly damaged thereby. Lead Plaintiffs assert four causes of action for: violation of Section 10(b) of the Exchange Act

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and Rule 10b-5 promulgated thereunder against Longtop and the Individual Defendants (Count One); violation of Exchange Act Section 20(a) against the Individual Defendants (Count Two); violations of Rule 10b-5 against DTTC (Count Three); and violation of Section 20(a) against Deloitte Limited (Count Four). Pursuant to Federal Rule of Civil Procedure 12(b)(6), DTTC now moves to dismiss Count Three. For the following reasons, DTTC's motion is granted.

II. BACKGROUND[1]

Longtop is a Cayman Islands corporation with principal offices in Hong Kong and Xiamen, China,[2] which has described itself as a " leading provider" of information technology services to China's financial sector.[3] Throughout the Class Period, Longtop reported strong financial growth: from fiscal year 2008 to fiscal year 2010,[4] Longtop's total revenues grew from $65.9 million to $161.9 million, and its net income grew from $2.9 million to $59 million.[5] Longtop attributed this success to its extremely high gross and operating margins.[6] For example, in fiscal year 2010, Longtop's reported gross and operating margins were 62.5% and 35.8%, respectively, while its peer companies' gross and operating margins were, respectively, between 15-50% and 10-25%.[7] On the strength of these figures, Longtop availed itself of the United States capital markets through an initial public offering (" IPO" ) on October 25, 2007 and a secondary offering on November 23, 2009.[8]

Longtop's access to the capital markets was aided by DTTC.[9] DTTC served as Longtop's outside auditor, in which capacity it issued unqualified audit opinions on Longtop's Class Period financial statements, and consented to the use of its audit reports in Longtop's registration statements filed with the United States Securities and Exchange Commission (" SEC" ) in connection with the IPO and the Secondary Offering.[10] Specifically, DTTC permitted Longtop to reproduce its audit report in the 2009 20-F it filed with the SEC. [11] DTTC also permitted Longtop, in connection with its Secondary Offering, to incorporate this audit report on a Form F-3 and in a prospectus filed with the SEC.[12] DTTC also allowed Longtop to attach its unqualified audit report to Longtop to its 2010 20-F.[13] The audit reports state that DTTC's audits were performed in " accordance with the standards of the Public Company Accounting Oversight Board [ (" PCAOB" ) ]," that Longtop's internal

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controls were adequate, and that DTTC " expressed an unqualified opinion" that Longtop's audited financial statements " present[ed] fairly, in all material respects, the financial position of Longtop ...." [14]

The Complaint alleges that Longtop's above-market operating and gross margins were the result of various fraudulent actions taken by Longtop, including disguising its true cost of revenue and employee-related expenses through a series of off-balance sheet transfers to a wholly owned entity, Xiamen Longtop Human Resources (" XLHRS" ); falsifying its cash position and bank loan balances by manipulating and lying about its bank records; and interfering with DTTC's audits.[15] Longtop's alleged fraud began to unravel on April 26, 2011, when Citron Research issued a report questioning Longtop's high margins and whether XHLRS was properly deemed an unrelated entity.[16] The next day, Bronte Capital issued a report questioning Longtop's need for the Secondary Offering, given that, relative to expenses, Longtop then had six times more cash than Microsoft.[17]

In the wake of these reports, Longtop's share price declined by approximately 26.4%.[18] To staunch the bleeding, Longtop held a conference call with investors on April 28, 2011, during which Longtop's Chief Financial Officer Derek Palaschuk denied any wrongdoing, and emphasized his close working relationship with DTTC.[19] The price of Longtop's ADSs rose nearly 11% by market's close that day.[20]

This rally was short-lived, as market analysts continued to publish reports (collectively with the Citron and Bronte reports, the " Short Seller Reports" ) speculating that Longtop was using the purportedly unrelated XLHRS to hide its losses and inflate its gross margins.[21] On May 27, 2011, the NYSE halted trading in Longtop's ADSs, citing " undisclosed material corporate developments ...." [22] In the face of these developments, and a continued decline in Longtop's ADSs, Palaschuk resigned on May 19, 2011, [23] On May 23, 2011, Longtop announced that DTTC had resigned as its outside auditor.[24] That same day, DTTC released to the public a letter (the " Resignation Letter" ) detailing the circumstances leading to its resignation.[25]

The Resignation Letter relates the following narrative. DTTC determined that follow-up visits to certain Longtop banks were warranted in order to complete Longtop's 2011 audit.[26] When DTTC followed up with the banks it identified serious defects with Longtop's financials, including falsified bank confirmation replies, statements by bank officials that they had no record of certain transactions, significant discrepancies between bank balances and bank confirmations previously received

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by DTTC (and memorialized in the books and records of Longtop), and significant bank borrowing not identified in previously received confirmations.[27] In light of these defects, DTTC initiated a " formal second round of bank confirmation[s]" on May 17, 2011, [28] This inquiry was soon halted by Longtop's obstructionist behavior, including calls to banks by Longtop asserting that DTTC was not their auditor, the seizure of documents on bank premises by Longtop agents, and refusals by Longtop to allow DTTC's staff to leave Longtop's premises unless they relinquished audit files.[29] On May 20, Longtop's Chairman, Ka Xiao Gong (" Ka" ), called DTTC's Eastern Region Managing Partner, Paul Sin, and informed him that Longtop had recorded fake revenues in the past, which they had offset with false cash.[30] Ka also stated that " senior management" was involved.[31] The letter further states that DTTC resigned as Longtop's auditor due to the falsity of Longtop's financial records, the deliberate interference by Longtop with the audit process, and the unlawful detention of DTTC's audit files.[32] The letter concludes by urging Longtop to make its required 8-K filing informing the public not to place reliance on DTTC's earlier audit reports, and by reminding Longtop of its obligations under the Securities Exchange Act of 1934.[33]

The NYSE began delisting proceedings against Longtop on July 22, 2011, and delisted Longtop on August 29, 2011,[34] On November 10, 2011, the SEC charged Longtop with failing to comply with SEC reporting requirements, based on Longtop's failure to file an annual report in fiscal year 2011, and based on DTTC's statement that the financial statements contained in Longtop's annual reports in 2008, 2009 and 2010 were no longer reliable.[35] The complaint in that action alleges that DTTC has thus far failed to comply with the SEC's investigation, " including producing documents in response to a subpoena...." [36] However, it appears that DTTC's failure to produce documents is the result of inconsistencies between the regulatory regimes of the United States and China, pending the resolution of which the SEC has moved for, and been granted, a stay of its enforcement action against Longtop. [37]

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A. Alleged Violations of Generally Accepted Auditing Standards (" GAAS" )

The Complaint alleges that DTTC violated a variety of accounting rules and principles found in the interpretive Statements on Auditing Standards (" AU" ) that are alleged to form a part of the GAAS.[38] The Complaint further alleges that Longtop's Class Period financial statements violated provisions of the Generally Accepted Accounting Principles (" GAAP" ) mandating the disclosure of certain material related-party transactions and requiring that financial statements fairly and completely represent an enterprise's economic resources and financial performance in a way that is useful to the investing public. [39] Consequently, DTTC statements that its audits were conducted in accordance with PCAOB standards and that Longtop's financial statements were GAAP compliant are alleged to be materially false.[40]

The Complaint alleges that DTTC failed to exercise the " [d]ue professional care" and " professional skepticism" required by the GAAS.[41] Specifically, the Complaint alleges that DTTC was reckless and fell short of GAAS standards because it failed to undertake any meaningful investigation of Longtop's bank and loan balances over the Class Period.[42] Similarly, the Complaint alleges that DTTC was reckless and violated GAAS standards because it failed to detect ...


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