Miller Inv. Trust v. Morgan Stanley & Co., CIVIL ACTION NO. 11–12126–DPW

• Court: United States District Courts. 1st Circuit. United States District Courts. 1st Circuit. District of Massachusetts
• Writing for the Court: DOUGLAS P. WOODLOCK, UNITED STATES DISTRICT JUDGE
• Citation: 308 F.Supp.3d 411
• Parties: MILLER INVESTMENT TRUST and Jura Limited, Plaintiffs, v. MORGAN STANLEY & CO., LLC and KPMG Hong Kong, Defendants.
• Docket Number: CIVIL ACTION NO. 11–12126–DPW
• Decision Date: 30 March 2018

308 F.Supp.3d 411

MILLER INVESTMENT TRUST and Jura Limited, Plaintiffs,
v.
MORGAN STANLEY & CO., LLC and KPMG Hong Kong, Defendants.

CIVIL ACTION NO. 11–12126–DPW

United States District Court, D. Massachusetts.

Signed March 30, 2018

308 F.Supp.3d 418

Laurence Rosen, The Rosen Law Firm, New York, NY, Adam M. Stewart, Thomas G. Shapiro, Shapiro Haber & Urmy LLP, Boston, MA, for Plaintiffs.

John P. Bueker, Randall W. Bodner, Ropes & Gray, Steven W. Hansen, Jeff Goldman, Morgan, Lewis & Bockius LLP, Jared A. Craft, Bingham McCutchen LLP, Boston, MA, Jeffrey Q. Smith, Morgan, Lewis & Bockius LLP, New York, NY, for Defendants.

MEMORANDUM AND ORDER

DOUGLAS P. WOODLOCK, UNITED STATES DISTRICT JUDGE

TABLE OF CONTENTS

I. FACTUAL BACKGROUND...419

A. Shengda's Note Offering and the Plaintiffs' Purchases ...419

B. KPMG–HK's Realization of Shengda's Overvaluation and Shengda's Bankruptcy ...420

C. Alleged Misrepresentations by KPMG–HK ...421

D. Impact of Misrepresentations on the Plaintiffs ...422

II. PROCEDURAL HISTORY...422

III. STANDARD OF REVIEW...425

IV. DISCUSSION...425

A. Section 18 Claim ...425

1. Pleading Requirements...425

2. False or Misleading Statements...427

a. Conformance of KPMG–HK's Audit of Shengda's Financial Statements and Internal Controls with PCAOB Standards...429

i. Failure to Investigate False Statements About SSCM by Shengda's CFO...431

ii. Internal Control Deficiencies...435

iii. Failure to Establish Direct Contact in the Confirmation Process...436

iv. Ignoring Red Flags...438

v. Alleged Violations After March 2010...440

vi. Import of the Magnitude of the Fraud and the East of its Discovery...441

b. Conformance of Shengda's Financial Statements with GAAP...441

c. Loss Causation...444

B. Negligent Misrepresentation Claim ...449

1. Pleading Requirements...449

2. False Information...450

3. Justifiable Reliance...451

IV. CONCLUSION...453

Plaintiffs Miller Investment Trust ("Miller") and Jura Limited ("Jura") seek to recover investment losses from purchases of $8.7 million of bonds offered by ShengdaTech, Inc. ("Shengda") made between December 2010 and February 2011. In March 2011, it was reported that Shengda had vastly overstated its revenues. Shortly thereafter, Shengda defaulted and declared bankruptcy. In December 2011, Miller brought this action alleging securities fraud against Defendants Morgan Stanley, which underwrote the offering, and KPMG Hong Kong ("KPMG–HK"), Shengda's auditor. The Plaintiffs allege that Morgan Stanley and KPMG–HK knew or should have known about misrepresentations of material fact made in the offering documents provided to the Plaintiffs on which Plaintiffs relied in deciding to purchase the Shengda bonds.

308 F.Supp.3d 419

The instant motion to dismiss pertains only to those claims asserted by Miller against KPMG–HK. Following several iterations of the complaint, after each of which KPMG–HK has moved to dismiss, now before me is KPMG–HK's motion for dismissal of the two counts against it set forth in the Third Amended Complaint: negligent misrepresentation under state common law and violation of § 18 of the Securities Exchange Act of 1934, 15 U.S.C. § 78r.

I. FACTUAL BACKGROUND

I recount the facts as alleged in the Third Amended Complaint as true, focusing primarily on those allegations pertaining to KPMG–HK.

A. Shengda's Note Offering and the Plaintiffs' Purchases

Shengda was a Nevada corporation with its principal place of business in the People's Republic of China. Third Am. Compl. (TAC) ¶ 37. Before its bankruptcy, Shengda primarily manufactured a chemical additive called nano-precipitated calcium carbonate, which is used to improve industrial materials such as paint, paper, plastic, and rubber. Id. It conducted its manufacturing operations through Chinese subsidiaries.¹ Id. ¶¶ 34, 38.

In 2010, Shengda sold an aggregate of $130 million of 6.5% senior convertible notes due in 2015 through a private placement offering closing in December 2010. TAC ¶¶ 1, 16, 219, 224. In connection with the offering, Morgan Stanley,² the underwriter, prepared a private placement memorandum ("PPM") that would be distributed to potential purchasers. Id. ¶¶ 2, 20, 23, 32, 33, 258. The PPM contained numerous financial documents relating to Shengda, including its 2008 and 2009 SEC Form 10–Ks, each of which contained an audit report from KPMG–HK for the respective fiscal years 2008 and 2009. Id. ¶¶ 2, 34, 258. Shengda retained KPMG–HK³ to serve as its independent auditor from November 2008 until April 2011, during which time KPMG–HK completed audits for fiscal years 2008 and 2009, and partially completed an audit for 2010. Id. ¶¶ 34, 58.

After receiving additional assurances from KPMG–HK as to the use of its audit reports and the accuracy of Shengda's financial statements, Morgan Stanley distributed the PPM to potential buyers, including Wellesley Investment Advisors, Inc. TAC ¶¶ 2, 23, 34, 220, 243, 258. Wellesley Investment Advisors is a registered investment adviser in Massachusetts that manages Miller, a mutual fund, and has full investment authority over the funds of Jura, a Bermuda corporation. Id. ¶¶ 28, 30–31. Relying on the information provided in the PPM and in Shengda's SEC filings, Miller purchased approximately $8 million of Shengda bonds (Shengda's 2015 Notes) between December 10, 2010 and February 16, 2011,⁴ id. ¶¶ 20–21, 29, 32, 243–244, from Morgan Stanley,

308 F.Supp.3d 420

through the private placement and four subsequent transactions. Jura, through Wellesley Investment Advisors, purchased $700,000 of Shengda convertible bonds in two purchases on December 12, 2010 and February 27, 2011. Id. ¶¶ 30–32, 243–245.

B. KPMG–HK's Realization of Shengda's Overvaluation and Shengda's Bankruptcy

In conducting its audit for Shengda for fiscal year 2010, KPMG–HK conducted additional procedures that it had allegedly assured the chair of Shengda's Audit Committee it would perform. TAC ¶¶ 17, 166. On March 1 and 2, 2011, KPMG–HK began contacting Shengda's customers, suppliers, and banks using publicly available contact information, and learned that many of Shengda's claims regarding business relationships and financial statements were false. Id. ¶¶ 17, 225–226. Specifically, KPMG–HK "could not confirm sales amounts, sales terms, and outstanding balances, discovered that many documents ShengdaTech provided to KPMG were crude forgeries, discovered that certain transactions had been with related parties without necessary disclosure, and that suppliers and customers denied engaging in business with ShengdaTech." Id. ¶ 226. The Plaintiffs contend that KPMG–HK would have discovered these issues earlier had it conducted its 2008 and 2009 audits consistent with governing auditing standards. Id. ¶ 227.

Beginning on March 2, 2011, and through a series of three memoranda thereafter, KPMG–HK informed Shengda's Audit Committee of its discovery of "potentially serious discrepancies and unexplained issues" during its audit of Shengda's financial statements for fiscal year 2010. TAC ¶¶ 226–227. Shengda immediately convened a special committee, composed of the independent directors on the Audit Committee and advised by a law firm and an accounting firm, to conduct an internal investigation. Id. ¶¶ 228–229. On March 14, NASDAQ suspended trading in Shengda's equity securities, thereafter stating that it would not resume trading until Shengda had "fully satisfied NASDAQ's request for additional information." Id. ¶¶ 230, 232. The next day, Shengda issued a press release announcing the appointment of the special committee "to investigate potentially serious discrepancies and unexplained issues relating to the Company and its subsidiaries' financial records." Id. ¶ 231.

In April 2011, KPMG–HK resigned as Shengda's auditor, stating that it had "doubts about management's representations provided to [KPMG–HK] in connection with [its] 2008 and 2009 audits of the consolidated financial statements and the effectiveness of internal control over financial reporting of the Company." TAC ¶ 233. KPMG–HK implored Shengda to make disclosures regarding any errors in previously issued audit reports to prevent future reliance on them. Id.

On May 5, Shengda filed a current report on Form 8–K with the SEC, stating that "KPMG previously informed the Company's Audit Committee of certain concerns arising during its incomplete audits of the Company's consolidated financial statements as of and for the year ended December 31, 2010, and the effectiveness of internal control over financial reporting as of December 31, 2010." TAC ¶ 234. It went on to identify issues related to bank balances, supplier transactions, VAT tax invoices, third-party sales and payments, customer sales, and the confirmation process. Id.

On June 9, Shengda announced that it was in default on the convertible bond securities issued in the 2010 private placement; the next day, all trading of Shengda stock was suspended by NASDAQ. TAC ¶¶ 235–236. The SEC thereafter commenced a regulatory...