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From Securities Regulation Daily, April 8, 2016

Auditor's conduct was at best negligent, not fraudulent

By Rodney F. Tonkovic, J.D.

In a summary order, a Second Circuit panel has affirmed a district court ruling finding that a fraud complaint brought against Shanghai-based independent auditor Deloitte Touche Tohmatsu CPA, Ltd. failed to state a claim. The court found that the complaint's allegations fell short of showing scienter and showed, at best, mere negligence (Special Situations Fund III QP, L.P. v. Deloitte Touche Tohmatsu CPA, Ltd., April 8, 2016, per curiam).

ChinaCast. In 2012, ChinaCast Education Corporation, Inc., a Chinese educational services company, disclosed that former executives had been misstating financials and embezzling funds for years. Investors in ChinaCast alleged that Deloitte, as ChinaCast's independent auditor, committed fraud under the Exchange Act when it issued a clean audit opinion for each year from 2007 through 2010. In their complaint, the investors pointed to a series of "red flags" that Deloitte would have uncovered if the firm had performed an audit according to PCAOB standards and GAAP.

Lower court dismisses. The district court dismissed the complaint with prejudice, finding that the allegations were insufficient to establish scienter. The court explained that the alleged red flags and accounting violations failed to tip the scales from negligence to recklessness. The court also found that the allegations supporting the complaint's claim under Section 18 for filing its allegedly misleading audit opinions with the SEC fell short of alleging the subjective falsity of Deloitte's opinions, which would be the only possible basis for Section 18 liability.

Affirmed. The circuit panel agreed with the district court that the investors' allegations fell short of showing scienter under the PSLRA and showed, at best, mere negligence. According to the court, the investors asserted that, had Deloitte checked the documentation underlying certain large transactions and assets on ChinaCast's books, it would have discovered the embezzlement and other misconduct. Nowhere, however, was it alleged that Deloitte was required to check this documentation, the court said.

The investors also contended that transactions with third parties reflected in the financial statements of certain ChinaCast subsidiaries constituted red flags. When viewed in context, the court explained, it was not fair to characterize the records of these transactions as fraud, except by hindsight. The court said that ChinaCast's public filings reported that these third parties provided services justifying the transactions, and there were no allegations that Deloitte knew that the public filings were false.

Turning to the claim under Section 18, the panel agreed with the district court's finding that the complaint failed to allege that Deloitte's opinions constituted false or misleading statements. The investors claimed that their allegations showed both that Deloitte lacked a subjective belief in its opinions and that its opinions were materially misleading because they omitted key facts. Since there were no allegations that Deloitte knew that ChinaCast's public filings were false, these allegations also failed. The district court's judgment was accordingly affirmed.

The case is No. 15-1813.

Attorneys: Sheila Sadighi (Lowenstein Sandler LLP) for Special Situations Fund III QP, L.P., Special Situations Cayman Fund, L.P., Columbia Pacific Opportunity Fund, L.P. and Fir Tree Value Master Fund, L.P. Gary F. Bendinger (Sidley Austin LLP) for Deloitte Touche Tohmatsu CPA, Ltd. William R. Maguire (Hughes Hubbard & Reed LLP) for Deloitte & Touche LLP.

Companies: 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.; Deloitte Touche Tohmatsu CPA, Ltd.; Deloitte & Touche LLP

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