Securities Regulation Daily Wrap Up, FRAUD AND MANIPULATION—2d Cir.: Plaintiffs claims against Puda Coal auditors go up in smoke, (May 20, 2016)

By R. Jason Howard, J.D.

An appellate panel has affirmed the judgment of the Southern District of New York in dismissing on summary judgment a securities class action against Puda Coal, Inc’s. auditors for failing to discover the CEO's fraudulent asset transfer to himself (In re Puda Coal Securities Inc. Litigation, May 20, 2016, per curiam).

Fraudulent transfer. Until 2011, Puda was a publicly traded, U.S.-listed company headquartered in China, which purportedly held, as its sole asset, a 90-percent ownership stake in Shanxi Puda Coal Group Co., Ltd., a coal supplier for steel manufacturing. Puda, however, was merely a shell company beginning in September 2009 when Puda’s chairman transferred Puda’s entire interest in Shanxi Coal to himself.

Accounting. The transfer was reflected in various documents filed in China’s State Administration of Industry and Commerce and shareholder meeting minutes for Shanxi Coal, but Puda’s financial statements for 2009 and 2010 included all of the assets, liabilities, revenues, expenses, and net income for Shanxi Coal. Hong Kong-based auditing firm Moore Stephens Hong Kong conducted the audits of Puda’s 2009 and 2010 financial statements and issued “clean opinions” pursuant to PCAOB standards.

After April 2011, when the Shanxi Coal transfer became public, Moore Stephens resigned as Puda’s auditor and announced that its 2009 and 2010 audit opinions could no longer be relied upon.

Class action. This class action followed, alleging Securities Act and Exchange Act violations. In support, the plaintiffs proffered Anita C.M. Hou as an expert. Hou admitted that she was not an expert on PCAOB standards and could not opine on whether the audits complied with PCAOB standards, but she testified that Moore Stephens failed to comply with the auditing standards of Hong Kong and/or the People’s Republic of China (PRC). Moore Stephens proffered Alexander H. Mackintosh as an expert in PCAOB standards who opined that Moore Stephens’s 2009 and 2010 audits fully complied with PCAOB standards.

District court. Summary judgment was granted in favor of Moore Stevens when the district court struck plaintiffs’ sole accounting expert, Hou, reasoning that, “Hou did not have the requisite expertise to offer opinions on any matters relevant to the case because she had no experience or expertise in PCAOB audits and because PCAOB provides the standard of conduct that Moore Stephens allegedly failed to satisfy.”

That lack of evidence meant the plaintiffs “could not raise a triable issue of fact regarding whether Moore Stephens egregiously departed from applicable professional standards of care.”

Appeal. The panel said that because Puda was a U.S.-listed company, the only auditing standards in question were those promulgated by PCAOB—not those of Hong Kong or PRC—and because Hou admitted to lacking experience and expertise in conducting or reviewing audits done according to PCAOB standards, she was therefore not qualified to opine on PCAOB auditing standards and accordingly, the district court appropriately struck Hou as an expert witness.

The panel also addressed the scienter requirement under Section 10(b) and said that the plaintiffs could not raise a triable issue of fact as to whether Moore Stephens was sufficiently reckless to be liable under Section 10(b) and that they fell short regardless of the expert testimony as they had “no factual basis for alleging that the 2009 and 2010 audits were ‘extreme departures’ from PCAOB standards ‘amounting to no audit at all’ because they cannot establish the PCAOB standard of ordinary care.”

Conclusion. The panel said there was “no evidence that Moore Stephens did not believe its ‘clean audit opinions’ for Puda’s 2009 or 2010 financial statements. Nor is there evidence that Moore Stephens omitted material facts about the basis for its audit reports.” The appellate panel’s ruling was by summary order and does not carry precedential effect.

The case is No. 15-2100.

Attorneys: Laurence M. Rosen (The Rosen Law Firm, P.A.) for Salomon Querub. Brian J. Massengill (Mayer Brown) for Moore Stephens Hong Kong.

Companies: Moore Stephens Hong Kong

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