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Special Situations Fund III QP, L.P. v. Deloitte Touche Tohmatsu CPA, Ltd.

United States District Court, S.D. New York

July 21, 2014

SPECIAL SITUATIONS FUND III QP, L.P.; SPECIAL SITUATIONS CAYMAN FUND, L.P.; COLUMBIA PACIFIC OPPORTUNITY FUND, L.P.; FIR TREE VALUE MASTER FUND, L.P.; FIR TREE CAPITAL OPPORTUNITY MASTER FUND, L.P.; LAKE UNION CAPITAL TE FUND L.P.; ASHFORD CAPITAL MANAGEMENT, INC.; ZS EDU L.P.; MRMP MANAGERS LLC; WHI GROWTH FUND QP, LP; DOUGLAS N. WOODRUM; ROBERT A. HORNE; HOWARD S. BERL; BRIGHTLIGHT CAPITAL PARTNERS LP; and TORTUS CAPITAL MASTER FUND, LP, Plaintiffs,
v.
DELOITTE TOUCHE TOHMATSU CPA, LTD.; DELOITTE & TOUCHE LLP; ANTONIO SENA; JUSTIN TANG; YIN JIANPING; RICHARD XUE; MICHAEL SANTOS; JOHN AND JANE DOES 1-10; and ABC CORPS. 1-10, Defendants

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For Special Situations Fund III QP, L.P., Special Situations Cayman Fund, L.P., Columbia Pacific Opportunity Fund, L.P., Fir Tree Value Master Fund, L.P., Fir Tree Capital Opportunity Master Fund, L.P., Lake Union Capital Fund, L.P., Lake Union Capital TE Fund, L.P., Ashford Capital Management, Inc., ZS EDU, L.P., MRMP-Managers, L.L.C., Douglas N. Woodrum, Robert A. Horne, Howard S. Berl, Whi Growth Fund QP LP, Tortus Capital Master Fund, LP, Brightlight Capital Partners LP, Plaintiffs: Amiad Moshe Kushner, Lowenstein Sandler LLP (NYC), New York, NY; Lawrence M. Rolnick, Lowenstein Sandler PC, Roseland, NJ; Sheila A. Sadighi, PRO HAC VICE, Lowenstein, Sandler LLP, Roseland, NJ; Thomas E. Redburn, Jr., PRO HAC VICE, Lowenstein, Sandler, Brochin, Kohl, Fisher, Boylan & Meanor, Roseland, NJ.

For Deloitte Touche Tohmatsu CPA, Ltd., Defendant: Gary Frederick Bendinger, LEAD ATTORNEY, Sidley Austin LLP(NY), New York, NY; David Andrew Gordon, PRO HAC VICE, Sidley Austin LLP, Chicago, IL; Elizabeth Leanne Howe, PRO HAC VICE, Sidley Austin LLP, Washington, DC; Michael Dana Warden, PRO HAC VICE, Sidley Austin LLP(Washington), Washington, DC.

For Deloitte & Touche L.L.P., Defendant: Jesse James, Hughes Hubbard & Reed, New York, NY; Savvas Antonios Foukas, William R. Maguire, Hughes Hubbard & Reed LLP (NY), New York, NY.

OPINION

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Edgardo Ramos, United States District Judge.

This case arises from allegations of an independent auditor's alleged failure to detect fraud at ChinaCast Education Corporation, Inc. (" ChinaCast" or the " Company" ), an educational services company in the People's Republic of China (" China" ). ChinaCast entered the U.S. capital markets through a reverse merger in 2006, and for several years, its common stock was traded on the NASDAQ. In 2012, the Company disclosed that, unbeknownst to its investors, and without consent from its Board of Directors, certain rogue employees, led by the Company's former Chairman and CEO, Ron Chan, had engaged in wide-ranging fraudulent activities, including, inter alia, misappropriation of proceeds from a stock offering, misrepresentation of ChinaCast's ownership interests, and pledging substantial portions of the Company's term deposits to cover debts of third parties. After a series of public announcements revealing the fraud, ChinaCast's stock price plummeted. Am. Compl. ¶ ¶ 5, 6, 45, 172-84, Doc. 4.

Plaintiffs in this action consist of an assortment of investors who, in the aggregate, purchased more than 20 million shares of common stock issued by ChinaCast. Id. ¶ 6. But rather than sue the Company, Plaintiffs contend that ChinaCast's Shanghai-based outside auditor, Deloitte Touche Tohmatsu CPA, Ltd. (" DTTC" ), and its U.S. affiliate, Deloitte & Touche LLP (" Deloitte U.S." ) (collectively, " Deloitte Defendants" ), as well as certain former ChinaCast officers and directors (the " Individual Defendants" ),[1] violated provisions of the Securities Exchange Act of 1934 (the " Exchange Act" ) and committed common law fraud by issuing and approving false statements in ChinaCast's public filings with the U.S. Securities and Exchange Commission (" SEC" ). Plaintiffs claim that ChinaCast's audited financial statements " carried the imprimatur of Deloitte -- one of the 'Big Four' global accounting firms -- whose name investors rely on as an independent auditor and gatekeeper of accurate financial reporting." Id. ¶ 1. Yet, " [h]ad Deloitte done even the most basic of audits," they " would have

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known that ChinaCast was a house of cards." Id. ¶ 10.

Plaintiffs assert causes of action for: violations of Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder, against DTTC and Individual Defendants (First and Third Causes of Action); violations of Section 20(a) of the Exchange Act against Deloitte U.S. (Second Cause of Action); violations of Section 18 of the Exchange Act against all Defendants (Fourth Cause of Action); and common law fraud under New York law against Deloitte Defendants (Fifth Cause of Action). Id. ¶ ¶ 51-171, 70, 85, 208.

Before the Court are Deloitte Defendants' respective motions to dismiss Plaintiffs' claims under Rule 12(b)(6) of the Federal Rules of Civil Procedure. Docs. 14, 32. For the reasons set forth below, the motions are GRANTED; however, the Court dismisses the First Amended Complaint (" FAC" ) without prejudice.

I. BACKGROUND[2]

A. The Parties

1. Plaintiffs

Plaintiffs are a group of investment funds, entities and individuals who purchased ChinaCast securities between March 31, 2008 through and including March 30, 2012.[3] Am. Compl. ¶ 1. Some of the Plaintiffs are closely associated with ChinaCast's current management. Individual Plaintiff Doug Woodrum is the Chief Financial Officer (" CFO" ) of ChinaCast. Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K), Doc. 34. In addition, ChinaCast Board Member Ned Sherwood co-founded and manages ZS Fund L.P., the general partner of Plaintiff ZS EDU L.P.; Mr. Sherwood beneficially owns shares held by Plaintiff ZS EDU L.P.; shares owned by Plaintiff MRMP Managers LLC are for the benefit of Mr. Sherwood's children; and Mr. Sherwood was the ChinaCast board designee of Plaintiff Fir Tree Funds. Bendinger Decl. Ex. 11 (Nov. 15, 2011 Schedule 14A Information at 5).

Plaintiffs claim that, collectively, they invested more than $96 million on more than 20 million shares of ChinaCast stock and, as a result of the Defendants' conduct, suffered " tens of millions" of dollars in investment losses. Am. Compl. ¶ 6.

2. Deloitte Defendants

" Deloitte" holds itself out as a global accounting firm comprised of member and network firms that conduct " integrated cross-border audits." Id. ¶ 51. Deloitte

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U.S. is a Delaware limited liability partnership located in New York, New York. Id. ¶ 32. DTTC is a Chinese auditing firm with headquarters in Shanghai, China. Id. ¶ 31.

B. Factual Allegations

1. ChinaCast Expands Its Business

ChinaCast is a Delaware corporation with principal offices in China, and has described itself as " a leading for-profit, post-secondary education and e-learning services provider in China." Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K). The Company was initially formed as a special purpose acquisition company called Great Wall Acquisition Corporation (" Great Wall" ) on August 20, 2003. Am. Compl. ¶ 39. In 2006, Great Wall identified ChinaCast Communications Holdings Limited (" CCH" ), an e-learning company incorporated in Bermuda and listed on the Stock Exchange of Singapore (" SGX" ), as a desirable acquisition target. Id. ¶ 40. Starting in 2000, the Chinese Ministry of Education granted licenses to approximately 68 universities to conduct undergraduate and post-graduate courses by distance learning. By 2003, CCH signed with more than 15 universities to use its satellite interactive distance learning network, serving over 50,000 students nationally. Thereafter, CCH expanded its business by signing additional K-12, IT and management training customers. Bendinger Decl. Exs. 3, 6 (2009 and 2010 Form 10-Ks at 2). On December 22, 2006, Great Wall obtained a majority of the outstanding shares of CCH and subsequently changed its name to ChinaCast Education Corporation. Am. Compl. ¶ 45. In 2007, ChinaCast acquired all remaining outstanding shares of CCH and terminated the SGX listing, effecting a " reverse merger" onto the NASDAQ exchange. Id. ¶ ¶ 4, 45; see also Bendinger Decl. Exs. 3, 6 (2009 and 2010 Form 10-Ks at 2).

Plaintiffs allege that " ChinaCast's business did not make it a complicated company to audit." Am. Compl. ¶ 4. ChinaCast's financial statements report that it majority-owns approximately twenty-five subsidiaries and variable interest entities. Its principal subsidiary is ChinaCast Technology (BVI) Limited, which, since 1999, has provided funding for satellite broadband Internet services through the satellite operating entities ChinaCast Company Ltd.-- Beijing Branch and ChinaCast Li Xiang Co. Ltd. (" CCLX" ).[4] Bendinger Decl. Ex. 3 (2010 Form 10-K at F-10-13). In 2007, ChinaCast engaged in limited business operations, and its primary assets were cash and term deposits. Am. Compl. ¶ 4. ChinaCast exclusively provided " distance learning" services from its inception until it acquired its first physical university in 2008. Id. ¶ 47. Between 2007 and 2010, the Company completed only " one or two major transactions per year." Id. In its 2008 Form 10-K, ChinaCast reported that, on April 11, 2008, its wholly owned subsidiary, Yu Pei Information Technology (Shanghai) Limited (" YPSH" ), acquired an 80% interest in Hai Lai Education Technology Limited (" Hai Lai" ), which, in turn, owned the Foreign Trade Business College of Chongqing Normal University

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(" FTBC" ), a traditional brick and mortar university. Id. ¶ 78.

After procuring Hai Lai in 2008, ChinaCast organized itself into two distinct groups: (1) the e-learning and training service group, encompassing all of the Company's business prior to the acquisition; and (2) the traditional university group, which offered bachelor and diploma programs to Chinese students. Id. ¶ 48; Bendinger Decl. Exs. 2-3 (Form 10-Ks at 2-3).

During the next two years, ChinaCast acquired two additional fully accredited universities: Lijang College of Guangxi Normal University (" Lijang College" ) and Hubei Industrial University Business College (" Hubei Industrial University" ). Am. Compl. ¶ ¶ 49-50. ChinaCast's 2009 Form 10-K reported that, on October 5, 2009, the Company completed the acquisition of East Achieve Limited, the holding company which beneficially owned 100% of Lijang College. Id. ¶ 89. ChinaCast's 2010 Form 10-K reported that, on August 23, 2010, the Company completed the acquisition of Wintown Enterprises Limited, the holding company that beneficially owned 100% of Hubei Industrial University. Id. ¶ 117.

ChinaCast's 10-K and 10-Q filings state that the Company paid a majority of the consideration for the acquisition of each of its three physical universities. Id. ¶ ¶ 79-81, 90-91, 118-19. These payments represented some of the most, if not the most, significant transactions on the Company's annual cash flow statements. Id. ¶ ¶ 82, 92, 118-20.

2. DTTC Audits ChinaCast's Financial Statements, 2007-2010

As of 2010, DTTC had worked with ChinaCast and its predecessor entity for more than ten years. Id. ¶ 31. Between 2007 and 2010, DTTC served as ChinaCast's independent public auditor of record. Id. ¶ 51. DTTC's duties included reviewing the Company's condensed financial information for each fiscal quarter and performing integrated audits of ChinaCast's consolidated financial statements in accordance with U.S. Public Company Accounting Oversight Board (" PCAOB" ) standards and Generally Accepted Accounting Principles (" GAAP" ). Id. ¶ ¶ 2, 31.

In making their decisions to invest in ChinaCast, Plaintiffs " read, reviewed and relied on" ChinaCast's public filings with the SEC, " including but not limited to its quarterly reports on Form 10-Q ... [and] annual reports on 10-KSB and 10-K, which included its audited year-end financial statements." Id. ¶ ¶ 9, 57, 70. Plaintiffs claim that " Defendants knew that Plaintiffs purchased ChinaCast securities in direct, eyeball reliance on" ChinaCast's audited financial statements, 10-Q and 10-K filings. Id. Particularly because ChinaCast's operations occurred abroad, Plaintiffs relied upon the fact that Deloitte, a " top global accounting firm," had a long-term relationship with ChinaCast and, through DTTC, represented that its audits comported with U.S. accounting standards; they trusted the Deloitte " stamp of approval." Id. ¶ ¶ 2-3, 9.

a. Statements Regarding Compliance with Accounting Principles and Standards; Financial Condition of Company

DTTC certified ChinaCast's audited financial statements and issued unqualified audit opinions for fiscal years 2007 through and including 2010, filed with the SEC on Form 10-K. Id. ¶ 8. In each of its audit opinions, DTTC stated (1) that it conducted its audit in accordance with PCAOB standards; and (2) that, in its opinion, " the consolidated financial statements present fairly, in all material respects, the financial position of the Company ... and the results

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of its operations and its cash flows," in conformity with GAAP. Id. ¶ ¶ 52, 56, 70, 85, 109; see also, e.g., Bendinger Decl. Ex. 3 (2010 Form 10-K at F-2).

b. Statements Regarding Internal Controls

DTTC was not engaged to perform an audit of the Company's internal controls over financial reporting for the 2007 fiscal year. Bendinger Decl. Ex. 4 (2007 Form 10-K at F-2). For fiscal years 2008 and 2009, DTTC made, inter alia, the following representations regarding ChinaCast's internal controls in the Company's Form 10-K filings:

o " We conducted our audit in accordance with the standards of the [U.S. PCAOB]. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. ... We believe that our audit provides a reasonable basis for our opinion."
o " Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management of override controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis."
o " In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of [the end of the year]...."
o " We have also audited, in accordance with [PCAOB standards], the consolidated financial statements and financial statement schedule [for the year]... [and] express[] an unqualified opinion on those financial statements and financial statement schedule."

Bendinger Decl. Ex. 5 (2008 Form 10-K at 29-30); Ex. 6 (2009 Form 10-K at 44); Am. Compl. ¶ ¶ 70, 85.[5]

DTTC expressed an adverse opinion on the Company's internal control over financial reporting as of December 31, 2010 based on a " [l]ack of sufficient skilled resources in the finance team to meet the demands of rapidly expanded businesses" and " [l]ack of contemporaneous documentation of certain decisions made by the Board of Directors." Bendinger Decl. Ex. 3 (2010 Form 10-K at F-2, 46).

c. Deloitte U.S.'s Role

Plaintiffs claim that Deloitte U.S. may be held responsible for DTTC's audit opinions, as well as ChinaCast's audited financial statements, because DTTC would not sign, and the Company did not submit, any SEC filings until Deloitte U.S. reviewed and approved them. Am. Compl. ¶ ¶ 32, 53-54. Deloitte U.S. controlled DTTC's audits of ChinaCast because it " had final authority over all U.S. GAAP matters," " directly communicated with ChinaCast's audit committee on key issues," provided consultation and " was involved in" all of

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ChinaCast's financial filings. Id. ¶ ¶ 32, 53, 187. Deloitte U.S.'s " involve[ment] in" making the decision to direct ChinaCast to write-off certain pre-paid expenses during the audit of its financial statements for the 2010 fiscal year exemplifies the manner in which Deloitte U.S. provided directions to DTTC throughout the " Deloitte-ChinaCast engagement." Id. ¶ 54. In that instance, Deloitte U.S.'s Washington, D.C. office " was directly involved in" communicating with and responding to concerns voiced by the SEC regarding the write-off, and it reviewed and approved an amendment to ChinaCast's 2010 Form 10-K addressing the SEC's comments. Id.

3. New Management Exposes the Fraud

Ron Chan, not sued herein, was appointed CEO of CCH in 1999 at CCH's inception. In connection with the CCH acquisition, the Company and CCH had agreed that Chan and certain other individuals would serve as directors of ChinaCast. ChinaCast appointed Mr. Chan to the position of Chairman and CEO on February 2, 2007. On the same date, ChinaCast appointed Daniel Tseung and Individual Defendants Yin Jianping, Justin Tang and Richard Xue to serve as directors. Bendinger Decl. Ex. 4 (2007 Form 10-K at 27).

After a highly contentious proxy battle initiated by Ned Sherwood in December 2011, ChinaCast's shareholders voted to elect a new slate of directors in early 2012. The new board included two inside directors (Mr. Chan and Individual Defendant Santos) and four outside directors (Mr. Sherwood, Daniel Tseung, Derek Feng and Stephen Markscheid) (the " Board" ). Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K). On March 26, 2012, the Board removed Ron Chan from his position as the Chairman and CEO and replaced him with Derek Feng. Am. Compl. ¶ 173. Individual Defendant Sena, who had signed a " loyalty pledge" to Chan, resigned from his position as CFO on the same day. Id. ¶ ¶ 189, 193. On March 29, 2012, the Board also removed Xiangyuan Jiang, the Company's former chief investment officer and president-China, another close ally of Mr. Chan. Bendinger Decl. Ex. 14 (Apr. 19, 2012 Form 8-K).

In an open letter to shareholders issued on April 2, 2012, the Board revealed that Mr. Chan and his cohorts had mounted " significant resistance" to the implementation of changes to the management team. Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K). As further explained in the letter, Ron Chan's contumacious conduct--which included thwarting the 2011 audit of the Company's financial statements--left the Board with no choice but to terminate him:

Ron Chan and his accomplices have refused to provide the necessary financial information so as to allow the Company's auditors (Deloitte) access to the Shanghai offices in order to complete their field work and enable the Company to issue its 2011 audited financial statements within the time periods required by the SEC. Additionally, this group of uncooperative managers has improperly declined to pay outstanding invoices for the services of Deloitte and various other outside advisors and service providers. Despite repeated efforts ... it became clear last week that there would be no cooperation forthcoming. Consequently, our Board had to take extraordinary measures by terminating Ron Chan.

Id. Perhaps unsurprisingly, Mr. Chan and other terminated executives " chose[] to unlawfully resist their terminations by refusing to return key company property, including corporate chops necessary to run the business in China," and Chan told Derek

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Feng that " he had no intention to relinquish the corporate chops." [6] Id.

The Board further reported that it had " uncovered questionable activities and transactions which raise the specter of possible illegal conduct by Ron Chan and his accomplices and may have led to the frustration of the audit of the Company's financial statements." Id.; Am. Compl. ¶ 174. In addition to initiating legal action against Ron Chan, the Company reported that it notified the SEC and the NASDAQ of these incidents. Notwithstanding the gravity of Mr. Chan's misdeeds, the Company concluded its letter by reiterating that ChinaCast " is a strong company with great assets, a dedicated employee base and a skilled and independent Board of Directors." Bendinger Decl. Ex. 2 (Apr. 2, 2012 Form 8-K).

NASDAQ suspended trading in ChinaCast's stock on the same day, due to the Company's failure to file an annual report for 2011. Am. Compl. ¶ 174; see also Complaint, SEC v. Chan Tze Ngon and Jiang Xiangyuan, No. 13 Civ. 6828 (TPG) (S.D.N.Y. Sept. 26, 2013). Trading did not resume until more than two months later, on June 25, 2012. Id.; Am. Compl. ¶ 180.

On April 19, 2012, the Company issued a statement confirming that ChinaCast had fallen victim to financial fraud, and provided progress reports on its internal investigation during the following months. Am. Compl. ¶ 177. Among other things, the Company relayed that Ron Chan and his allies " remov[ed] or destr[oyed] a substantial portion of the financial documents that were located in the finance offices of the Company's Shanghai headquarters," and that they " stole some of the computers believed to be utilized by the finance department" after forcibly gaining entry. Bendinger Decl. Ex. 13 (May 14, 2012 Form 8-K); Ex. 14 (Apr. 19, 2012 Form 8-K at 2).[7] Additionally, the Company noted that current management did not have access to all of the Company's accounts, and that it was trying to obtain access to additional bank records in order to investigate the transfer of approximately $120 million from two of ChinaCast's subsidiaries, CCT Shanghai and YPSH, from July 2011 to April 2012, without the Board's knowledge or consent. Bendinger Decl. Ex. 13 (May 14, 2012 Form 8-K at 4).

Ultimately, on December 21, 2012, ChinaCast " instructed investors to no longer rely on the Company's audited financials for 2009 and 2010." Am. Compl. ¶ ¶ 177-82. The Company reported that it had uncovered the following fraudulent activities ( see id.):

o Non-bank borrowings.

Without the Board's knowledge or consent, the Company took out a series of short-term, high-interest rate loans from a

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number of companies, friends and family members related, and unrelated, to prior management. As a result, previously issued financial statements understated borrowings on " various dates" from at least the fourth quarter of 2009 to the third quarter of 2011. Some individuals also filed claims against the Company for non-repayment of debts that the Company's previously issued financial statements failed to disclose. The Company reported that it was only able to obtain bank records and legal documentation to corroborate some of these undiscovered borrowings, and had not determined the volume of loans that remained outstanding.
o Interest in a purported majority-owned subsidiary.

ChinaCast's financial statements previously reported that it had a majority indirect ownership interest in CCT HK, but according to documents obtained from the Hong Kong Companies Registry, Ron Chan has owned 50% of CCT HK since 2003. The Company only owns an approximately 49.2% indirect equity interest in CCT HK; thus, it should not have been consolidated as a majority-owned subsidiary in the Company's previously issued financial statements. The Company reported that it was continuing to investigate how Mr. Chan acquired his ownership stake in CCT HK without the Board's knowledge or consent.

o December 2009 stock offering proceeds.

Without the Board's knowledge or consent, Ron Chan transferred at least $35 million of the $44 million in proceeds from the Company's 2009 public common stock offering to entities outside the Company's group structure (i.e., CCT HK).

o 2009 and 2010 year-end cash equivalents and term deposits.

Without the Board's knowledge or consent, prior management pledged at least $36 million of the $75 million classified as term deposits on its year-end 2009 balance sheet to guarantee the debts of various third parties, many of whom appear to operate outside of the scope of ChinaCast's business. Correcting for these secret pledges, the cash available from term deposits as of December 31, 2009 would have been reduced from $75 million to $38 million or less. Similarly, without the Board's knowledge or consent, prior management pledged at least $91 million of the $107 million classified as term deposits on the Company's 2010 year-end balance sheet to cover the debts of various third parties. Adjusting for these pledges, the cash available from term deposits as of December 31, 2010 would have been reduced from $107 million to $16 million or less.

o January 2010 stock issuance proceeds.

The Company's previously issued financial statements reported that Thriving Blue Limited, a BVI company owned by Ron Chan and Individual Defendants Sena and Santos, paid $5 million to purchase 692,520 shares of common stock, but new management was unable to confirm from statements for the Company's known bank accounts that it ever received the $5 million.

o College Acquisitions.

The Board reported that it would be continuing to investigate its suspicions that ChinaCast never made the payments that it claimed to have spent on the acquisition of its three brick and mortar universities.

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ChinaCast's stock price dropped dramatically after the news of the fraud emerged: in early 2012, it traded at more than $6.00 per share; on December 21, 2012, it closed at ten cents per share; and on March 15, 2013 it closed at 14 cents per share. Id. ¶ ¶ 6, 172, 183.

On March 25, 2013, the Company announced that its financial statements in annual and quarterly reports for fiscal years 2007 through 2010, and the first three quarters of 2011, should not be relied upon, and that, effective March 19, 2013, the Board dismissed DTTC from its position as the Company's independent accountant. Bendinger Decl. Ex. 15 (Mar. 25, 2013 Form 8-K). Internal and government ...


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