In re Puda Coal Securities Inc., Litigation
2014 WL 2915880, 30 F. Supp. 3d 230 (2014)
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Rule of Law:
In a securities fraud action against an auditor, a plaintiff cannot survive summary judgment on the element of scienter without providing admissible expert testimony establishing the applicable professional standard of care (e.g., PCAOB standards) and showing the auditor's conduct was an extreme departure from it.
Facts:
- Puda Coal Inc. ('Puda') was a U.S. publicly traded company whose primary asset was a 90% ownership interest in a Chinese coal supplier, Shanxi Puda Coal Group Co., Ltd. ('Shanxi Coal').
- In September 2009, Puda's chairman, Ming Zhao, secretly arranged for the transfer of Puda's entire interest in Shanxi Coal to himself, effectively leaving Puda as a shell company.
- This fraudulent transfer was documented in filings with China's State Administration of Industry and Commerce (SAIC).
- Moore Stephens Hong Kong ('MSHK') audited Puda's financial statements for the fiscal years 2009 and 2010.
- During its audits, MSHK did not independently obtain SAIC filings to confirm Puda's ownership of Shanxi Coal, relying instead on management representations, an outdated business license, and an unsigned legal opinion.
- MSHK issued 'clean' audit opinions for 2009 and 2010, which were included in Puda's SEC filings, stating that Puda's financial statements fairly represented its financial position.
- In July 2010, Ming Zhao, as the new secret owner of Shanxi Coal, transferred a 49% stake in the company to a state-owned private equity fund.
- In April 2011, a research report publicly exposed the fraudulent transfer of Shanxi Coal, causing Puda's stock to collapse and trading to be halted by the SEC.
Procedural Posture:
- Shareholders of Puda Coal Inc. filed multiple class-action lawsuits in the U.S. District Court for the Southern District of New York against various parties, including auditors Moore Stephens Hong Kong ('MSHK') and Moore Stephens, P.C. ('MSPC').
- The lawsuits were consolidated, and plaintiffs filed a Second Consolidated and Supplemental Amended Complaint alleging violations of federal securities laws.
- After discovery, the Auditor defendants moved for summary judgment, arguing plaintiffs failed to raise triable issues on scienter and subjective falsity.
- The Auditor defendants also moved to exclude plaintiffs' sole auditing expert, Anita C.M. Hou.
- Plaintiffs moved to exclude the Auditors' rebuttal experts.
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Issue:
Does a plaintiff in a securities fraud case raise a triable issue of fact as to an auditor's scienter where the plaintiff fails to provide admissible expert testimony establishing that the auditor's conduct was an extreme departure from the applicable professional standards of care?
Opinions:
Majority - Forrest, J.
No. A plaintiff fails to raise a triable issue of fact as to an auditor's scienter without presenting admissible expert testimony on the relevant standard of care. To establish scienter based on recklessness against an auditor, a plaintiff must show the auditor's conduct was an 'extreme departure from the standards of ordinary care,' amounting to a 'pretended audit.' In this case, the relevant standard of care is the Public Company Accounting Oversight Board (PCAOB) standards. Plaintiffs failed to offer a qualified expert on PCAOB standards; their proposed expert, Anita Hou, was an expert in Hong Kong and PRC standards and was excluded as irrelevant and potentially misleading to a jury. Without expert testimony to explain what PCAOB standards require and how MSHK's actions constituted an egregious departure, a lay jury cannot determine whether the audit was reckless. In contrast, the Auditors provided unrebutted expert testimony that their work complied with PCAOB standards. Furthermore, plaintiffs failed to show subjective falsity, as there was no evidence the Auditors disbelieved their own opinions when they were issued.
Analysis:
This decision reinforces the high evidentiary bar for proving scienter against auditors in securities fraud litigation. It underscores that plaintiffs cannot rely on 'fraud by hindsight' or simply point to red flags and alternative audit procedures that could have been performed. The court's exclusion of the plaintiff's expert and subsequent grant of summary judgment establish that in technically complex cases, admissible expert testimony is indispensable for defining the professional standard of care and demonstrating a defendant's reckless deviation from it. This ruling protects auditors from liability where plaintiffs fail to translate allegations of poor judgment into evidence of a 'pretended audit' that approximates an intent to defraud.
