United States District Court, S.D. New York
IN RE LONGTOP FINANCIAL TECHNOLOGIES LIMITED SECURITIES LITIGATION
[Copyrighted Material Omitted]
[Copyrighted Material Omitted]
For Lead Plaintiffs: Kimberly A. Justice, Esq., John A. Kehoe, Esq., John J. Gross, Esq., Kessler Topaz Meltzer & Check, LLP (PA), Radnor, Pennsylvania; Daniel L. Berger, Esq., Jeff A. Almeida, Esq., Deborah A. Elman, Esq., Reena S. Liebling, Esq., Grant & Eisenhofer, P.A. (NY), New York, New York.
For DTTC: Gary F. Bendinger, Esq., Gazeena K. Soni, Esq., Sidley Austin LLP, New York, New York; Michael Dana Warden, Esq., Sidley Austin LLP, Washington, D.C.; David Andrew Gordon, Esq., Sidley Austin LLP, Chicago, Illinois.
Shira A. Scheindlin, U.S.D.J.
OPINION AND ORDER
Lead plaintiffs Danske Invest Management A/S and Pension Funds of Local No. One, I.A.T.S.E. (collectively, " Lead Plaintiffs" ), as well as additional plaintiff Pompano Beach General Retirement System (together with Lead Plaintiffs, " Plaintiffs" ), bring this putative class action on
behalf of themselves and others similarly situated (the " Class" ) against Longtop Financial Technologies, Ltd. (" Longtop" ), its former director and CEO Weizhou Lian a/k/a Wai Chau, its former CFO Derek Palaschuk (together with Weizhou Lian, the " Individual Defendants" ), and its auditor Deloitte Touche Tohmatsu CPA Ltd. (" DTTC" ). 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 October 24, 2007 through May 17, 2011, inclusive (the " Class Period" ), and who were allegedly damaged thereby. Lead Plaintiffs assert three causes of action for: violation of Section 10(b) of the Exchange Act 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); and violation of Section 10(b) and Rule 10b-5 against DTTC (Count Three).
Previously, DTTC successfully moved to dismiss Count Three of the Consolidated Class Action Complaint (" CAC" ) for failure to state a claim. Lead Plaintiffs subsequently filed the Amended Consolidated Class Action Complaint (the " Amended Complaint" ), using discovery obtained from Palaschuk, who had unsuccessfully moved to dismiss prior to DTTC's appearance in the case. At a hearing held on January 8, 2013, DTTC orally moved to dismiss the Amended Complaint on the basis that the use of discovery to support the Amended Complaint violates the Private Securities Litigation Reform Act of 1995 (" PSLRA" ) stay of discovery, and I denied this motion. Presently before the Court is DTTC's motion to dismiss the Amended Complaint under Federal Rule of Civil Procedure (" Rule" ) 12(b)(6). For the following reasons, the motion is granted.
A. Procedural Posture
I issued an Opinion and Order (the " Dismissal Opinion" ) granting DTTC's motion to dismiss Count Three of the CAC on November 14, 2012. The Dismissal Opinion rested on the grounds that the CAC failed to adequately allege: (1) scienter on the part of DTTC;  and (2) that DTTC's Class Period audit opinions contained material misrepresentations of fact, i.e., statements " grounded on a specific factual premise that is false, and that [DTTC] did not 'genuinely or reasonably believe . . . .'"  Lead Plaintiffs were granted leave to amend within thirty days of the Order, and subsequently filed the Amended Complaint, which draws support from documents that Lead Plaintiffs received in response to discovery requests served on Palaschuk.
B. Summary of Facts Re-Alleged in the Amended Complaint
This section summarizes factual allegations common to the Amended Complaint and the CAC. These facts were previously described in the Dismissal Opinion, and
are presumed to be true for the purposes of this motion.
Claim Three of the CAC charged DTTC with violating Section 10(b) and Rule 10b-5 by issuing unqualified audit opinions on behalf of Longtop between June 29, 2009 and May 17, 2011. During this period, Longtop reported very strong financial results, but these results were inflated by its fraud. Longtop's fraudulent actions included hiring its employees through a shell company, Xiamen Longtop Human Resources (" XLHRS" ), in order to hide its true cost of revenue; falsifying its cash position and bank loan balances by manipulating its bank records; and interfering with DTTC's audits.
Beginning on April 26, 2011, Longtop's fraud began to unravel as short-sellers began issuing reports calling Longtop's financial results into question. On May 23, 2011, Longtop announced that DTTC had resigned as its outside auditor. That same day, DTTC released to the public a letter (the " Resignation Letter" ) revealing that DTTC's attempt to conduct a second round of bank confirmations at Longtop had been cut short by Longtop's deliberate interference. The Resignation Letter further stated that Longtop's CEO had admitted that Longtop's books were fraudulent, and that DTTC had resigned due to this admission and Longtop's deliberate interference with its audit. The letter concluded by suggesting that Longtop investigate its liability under the securities laws. Subsequently, the NYSE halted trading on Longtop's ADSs on May 27, 2011, began delisting proceedings against Longtop on July 22, 2011, and delisted Longtop on August 29, 2011.
C. New Facts Alleged in the Amended Complaint
The Amended Complaint lengthens the class period alleged in the CAC by including allegations relating to two additional audit opinions by DTTC. The Amended Complaint also adds four categories of substantive allegations to the CAC, concerning: (1) internal control deficiencies and risk factors at Longtop; (2) confirmation of revenue contract terms; (3) information DTTC received from third parties; and (4) XLHRS and Longtop's social welfare payments. These additions to the CAC are summarized below.
1. Extended Class Period
The Amended Complaint adds allegations based on audit opinions of DTTC's that were publicized on October 24, 2007 and July 1, 2008, thereby lengthening the class period. Count Three of the Amended Complaint therefore rests on audit opinions issued by DTTC in connection with: (1) Longtop's October 24, 2007 SEC Rule 424(b)(4) prospectus, issued in connection with its initial public offering;  (2) Longtop's 2008 Form 20-F, issued on July 1;  (3) Longtop's 2009 Form 20-F, issued July 29;  (4) Longtop's November 17, 2009 secondary offering;  and (5) Longtop's 2010 Form 20-F, issued on July 16.
The circumstances surrounding the October 2007 audit opinion are as follows. In preparation for Longtop's U.S. IPO, DTTC was engaged in 2006 to audit the consolidated financial results that Longtop had reported, under the Chinese version of GAAP,
for the years 2004-2006 and for the three month period ending in
March 31, 2007. Longtop's October 24, 2007 Rule 424(b)(4) prospectus incorporated the results of this audit, including statements by DTTC that " '[it] conducted [its] audits in accordance with the standards of the Public Company Accounting Oversight Board (United States) [(" PCAOB" )][; ]'" and that Longtop's " 'consolidated financial statements present fairly, in all material respects, [its] financial position . . . as of December 31, 2006 and 2006 and March 31, 2007, in conformity with [United States GAAP.]'"  The prospectus also quoted DTTC stating that: " '[Longtop] is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting . . . .'" 
2. New Substantive Allegations
a. Internal Control Deficiencies and Risk Factors
Plaintiffs alleges that DTTC was aware of internal control deficiencies at Longtop at least as early as 2007, and of " red flags at Longtop that gave rise to a significant risk of management fraud" at least as early as May 2008, but that DTTC nevertheless issued audit opinions on March 31, 2009 and 2010 stating that, in its opinion, Longtop had " 'maintained, in all material respects, effective internal control over its financial reporting.'"  The Amended Complaint supports these allegations with references to the following documents: (1) an agenda for a May 29, 2007 meeting with Longtop's audit committee at DTTC's offices; (2) draft meeting minutes for a November 15, 2007 Longtop Audit Committee meeting at DTTC's offices; (3-4) management letters prepared by DTTC to be sent to Longtop's Board of Directors, dated June 29 and August 2, 2007; (5) the draft minutes of a February 20, 2008 meeting between Longtop's Audit Committee and DTTC; (6) a presentation that DTTC made to Longtop on May 26, 2008; (7) a presentation that DTTC made to Longtop on May 26, 2009; and (8) a presentation that DTTC made to Longtop on August 12, 2010.
The first four of these documents arose out of the auditing work that DTTC performed in advance of Longtop's U.S. IPO. Plaintiffs allege that the May 29, 2007 meeting agenda states that " '[m]aterial weaknesses/significant deficiencies may exist' within Longtop's internal controls[,]" and that " 'Deloitte will provide [a] management letter'" explaining these potential deficiencies. It further alleges that the November 15, 2007 draft meeting minutes state that " '[m]aterial weaknesses/significant deficiencies may exist and a lot of work is required.'"  Finally, the June 29 and August 2, 2007 management letters prepared by DTTC to be sent to Longtop's Board of Directors state that DTTC had " 'considered [Longtop's] internal controls over financial reporting as a basis for designating audit procedures that are appropriate in the circumstances[,]" and, after this review, had identified " certain matters involving [Longtop's] internal control over financial reporting that [DTTC] consider[ed] to be material weaknesses or significant
deficiencies under standards established by the PCAOB[,]" as well as " other control deficiencies involving [Longtop's] internal control over financial reporting as of March 31, 2007." 
Plaintiffs allege that, as of Longtop's IPO, DTTC knew of a risk of management override and of problems with Longtop's reporting department, but that " nothing was done to alert the investing public of these deficiencies."  However, the Form F-1 filed by Longtop on October 2, 2007 discloses that Longtop was a privately held company, with " limited accounting personnel" prior to its IPO, and that DTTC had identified a " material weakness for 2006[,]" and a " significant deficiency and a large number of other deficiencies in [Longtop's] internal controls" for 2006 and the three months ending in March 31, 2007.
The remaining documents referenced in this portion of the Amended Complaint were created after Longtop's IPO. Plaintiffs allege that the phrase " [m]aterial weaknesses/significant deficiencies may exist and a lot of work is required[,]" is repeated in the draft minutes of the February 20, 2008 meeting, and that these minutes also state that " [significant work [is] required in [Longtop's] corporate reporting department."  It further alleges that DTTC's May 26, 2008 presentation states that Longtop was " under significant pressure of [sic] profitability or trend level expectations of [sic] . . . external parties (particularly expectations that are unduly aggressive or unrealistic), including expectations created by management[,]"  as well as stating that Longtop's " current internal controls may not meet the evolving demands in business, . . . caus[ing] additional management and control risk for [Longtop]," including the " potential risk of management override of control." 
Plaintiffs allege that in a follow-up presentation, dated May 26, 2009 and titled " Longtop Technologies Limited [Sarbanes-Oxley (" SarBox" )] 404 Attestation Status Update," DTTC noted that its planned response to the audit risks that it had identified at Longtop would be to " [i]ncrease professional skepticism of all personnel involved in the audit engagement."  It further alleges that, despite this planned response, in an August 12, 2010 presentation titled " [Fiscal Year]
2011 Client Service Plan," DTTC identified the same internal control deficiencies and risk factors, and noted that it intended to " perform a test of internal controls or substantive procedures . . . ."  On the basis of these facts, the Amended Complaint alleges that DTTC " should have issued an adverse opinion on Longtop's internal controls over financial reporting as of March 31, 2009 and 2010, communicated that material weaknesses existed in Longtop's internal controls, and informed investors that the Company's internal control over financial reporting was not effective." 
b. Confirmation of Revenue Contract Terms
The second category of new allegations in the Amended Complaint relates to DTTC's failure to confirm the terms of Longtop's major revenue contracts. As an initial matter, the Amended Complaint notes that the August 2 and June 19, 2007 letters that DTTC sent to Longtop stated that " [b]ank reconciliation procedures and review . . . were not documented as part of the accounts closing process[,]" and recommended that " [b]ank reconciliation statements should be prepared and reviewed by an independent supervisor on a timely basis to ensure that cash items are properly recorded." 
Plaintiffs then allege that in April 2009, a Longtop officer informed a DTTC employee that obtaining direct confirmation of Longtop's major revenue contracts would unduly delay the filing of Longtop's Form 20-F for the fiscal year ending March 31, 2009. After a back-and-forth between the Longtop officer, Palaschuk, and the DTTC auditor, during which the DTTC auditor initially insisted that " confirmation is a required procedure[,]" the DTTC auditor eventually acceded to Longtop's request that the revenue contracts be confirmed through alternate revenue testing.
Plaintiffs allege that, had DTTC insisted on directly confirming the revenue contracts, it would have discovered Longtop's fraud. It supports this allegation with reference to a series of e-mails sent by Palaschuk to Longtop's CEO in 2008, in which Palaschuk states that " Longtop has a culture where they book accounting entries without contracts, which I have never seen  in a company[,]" and further states that Longtop's accountants " rely upon [invoices] and hand written descriptions" rather than actual contracts in booking revenues, despite the fact that those " documents [could easily] be forged." 
c. Information from Third Parties
The third category of new allegations in the Amended Complaint relates to three instances where information which allegedly should have put DTTC on notice of Longtop's fraud was brought to DTTC's attention by third parties. First, the Amended Complaint alleges that Wedge Partners, a U.S. equity analyst, published three reports (the " Wedge Reports" ) on February 4, February 11, and March 23, 2010, calling into question Longtop's staffing arrangement with XLHRS.
Second, Plaintiffs allege that in October 2010 -- several months after the publication of Longtop's 2010 Form 20-F, containing the final Class Period statement made by DTTC -- partners in DTTC's Beijing office met with the CFO of YTEC, one of Longtop's chief competitors and a company which had long accused Longtop of over-reporting revenue. At this meeting, YTEC's CFO allegedly informed DTTC's Beijing partners of potential improprieties at Longtop, whereupon the Beijing partners informed DTTC's Shanghai branch, which was tasked with auditing Longtop. The Amended Complaint further alleges that an audit partner at DTTC subsequently told Palaschuk that, because the matter was discussed by DTTC's Beijing Partners, it was " very high profile," and as such, DTTC had to perform " additional [audit] procedures." 
Third, Plaintiffs allege that on November 2, 2010, a meeting was held between Longtop and DTTC, and that the meeting minutes reveal that the purpose of the meeting was to discuss " market rumors" that had been brought to Longtop's attention. These rumors included questions as to Longtop's above market margins, its use of XLHRS, and whether its software development revenue from China Construction Bank (" CCB" ) was overstated.
Regarding CCB, the meeting minutes state that " [a] person at CCB had questioned Longtop's more than U.S. $30 million in 2010 fiscal revenue from CCB and said the number was closer to 'Rmb30 million,' Longtop has no standardized software contracts with CCB and that Longtop was not an approved vendor at CCB."  The minutes go on to state that Longtop had arranged for analysts concerned about its relationship with CCB to meet with " CCB people in the Beijing development center," and concludes that " [f]rom an investor relations point of view, as these allegations are untrue, they will work themselves out." 
Plaintiffs allege that at the meeting, DTTC suggested that Longtop hire an independent consultant to investigate Longtop's revenues from CCB, but that Longtop rejected the suggestion. The meeting minutes reveal that DTTC made this suggestion despite the fact that it had " seen no indications of fraud or that Longtop's revenue from CCB is inaccurate[,]" and that Longtop stated that it " would confirm with . . . legal counsel whether . . . an investigation was necessary.
Regarding XLHRS, the minutes state that:
Deloitte was aware of questions in the market over Longtop's use of third party outsourcing companies and that Longtop had held a conference call with investors in March 2010 to address this issue. There were no accounting issues as this structure had been used for almost 4 years, is supported by legal opinions, disclosed in the 20F and the agreements are on file with the SEC. No followup required.
Finally, the minutes state that, at the meeting, Longtop's management gave a number of explanations for Longtop's above-market margins, including, e.g., " [a] comprehensive high quality solution offering and a wide customer base allowing the efficient cross selling of solutions[,]" heavy use of modular, proprietary intellectual property, and a back-office in Xiamen (which was cheap relative to Beijing). Based on these explanations, the meeting minutes state that no follow-up was required regarding Longtop's above-market margins.
d. Welfare Payments
The fourth category of new allegations against DTTC in the Amended Complaint relates to Longtop's underpayment of its welfare obligations. The upshot of these allegations is that DTTC was aware that Longtop was using XLHRS to evade paying its employee welfare obligations under Chinese law, and that it was therefore reckless for not investigating further and ferreting out XLHRS's alleged role in Longtop's fraud. (In addition, the Amended Complaint repeats the allegation of the CAC that DTTC was reckless in stating that XLHRS and Longtop were not related parties in audit opinions incorporated in Longtop's 2008, 2009, and 2010 Forms 20-F).
Plaintiffs allege that DTTC knew that Longtop had underpaid its social welfare obligations at least as early as 2007. It supports this allegation with reference to the agenda prepared for a May 29, 2007 meeting between DTTC and Longtop. This agenda reveals that Longtop had based its level of welfare payments for the years 2004-2006 -- prior to the Class Period -- on its interpretation of welfare law, and that, on the basis of this interpretation, it had made welfare payments of $475,000, while accruing a liability of $1,258,000 for its " maximum potential welfare payment . . . ."  The agenda further notes that Longtop had transferred approximately eight hundred employment contracts to XLHRS, but had not " accrued for interest or penalties on the basis [that] the likelihood is remote and the amounts are unknown." 
Plaintiffs further allege that, in a memo to file dated July 28, 2008, a Longtop officer noted that Longtop had underpaid its welfare obligations in fiscal years 2004 through 2006, but had accrued additional expenses in case of an investigation by the Chinese government. This accrued liability was to be written off if a government investigation failed to arise within five years.[ ...