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From Securities Regulation Daily, May 26, 2016

Insufficient showing of scienter tanks complaint over KPMG energy company audit

By Kevin Kulling, J.D.

A federal court has dismissed a complaint against KPMG that alleged it failed to identify and respond to red flags in connection with its position as auditor for former oil and gas services company Poseidon Concepts. The court said that the complaint could not rely on events that occurred after KPMG issued its audit report to establish scienter (In re Poseidon Concepts Securities Litigation, May 24, 2016, Cote, D.).

Poseidon Concepts. Poseidon was a Canadian corporation with administrative offices in Calgary. The company developed large modular above ground pools referred to as tanks for storing the vast quantities of fluid used in fracking. The company used the tanks in its own operations and offered the tanks for lease to other oil and gas companies. Poseidon ceased U.S. operations after it filed for bankruptcy in 2013.

The company’s United States operations were conducted from an office in Denver through its subsidiary, Poseidon Concepts, Inc., which was managed by Joseph Kostelecky, the former vice president of U.S. operations. Kostelecky previously settled SEC charges involving financial fraud at the company.

Take or pay. About a quarter of Poseidon’s 2011 revenue was generated from the pay portion of “take or pay” master agreements. In the take or pay contracts, Poseidon agreed to make its tanks available to a customer. If the customer did not use the tanks during the contract period, it had to pay a minimum daily rate as a penalty, which was the pay portion of the take or pay contract (the minimum pay rate). If the customer actually used the tanks, it had to pay a higher rate (the live rate).

Poseidon issued master agreements and field tickets for its services. In the oil and gas service industry, service providers usually entered into a master agreement that governed the terms of the services for important contracts, according to the court’s opinion. Once services were provided pursuant to the master agreement, the service provider issued the customer a field ticket, which was signed by the authorized representatives of both the service provider and the customer. The field ticket was then used to generate an invoice that was sent to the customer.

Allegations. The lead plaintiff alleged that much of Poseidon’s reported revenue was fraudulently recognized when virtually all of Poseidon’s reported 2011 revenues derived from minimum pay rates derived from transactions in which there was no evidence that customers had signed a master agreement or a field ticket.

The complaint against KPMG revolved around two statements made in its audit report for Poseidon’s 2011 annual financial statements.

The first statement involved KPMG’s opinion that the financial statements fairly presented Poseidon’s financial position in accordance with International Financial Reporting Standards (IFRS), while the second statement said KPMG conducted its audit in accordance with Canadian Generally Accepted Auditing Standards.

The complaint alleged that KPMG violated Canadian Accounting Standards, which require an auditor to determine whether it should modify the audit in the face of red flags. The complaint asserted that KPMG did not modify its audit procedures or perform a more intensive audit in the face of several red flags, such as Poseidon’s weak internal accounting systems, field discounts issued by Poseidon sales representatives, meetings where the 2011 annual filing was discussed and other documentation.

Secondly, the complaint alleged that KPMG falsely stated that in its “opinion,” the consolidated financial statements present fairly, in all material respects, the consolidated financial position of Poseidon in accordance with IFRS.

Scienter. The court focused on whether the complaint adequately pleaded that KPMG acted with the requisite scienter. The court said that red flags appearing after publication of the 2011 audit report could not support an inference of knowing misconduct in making the statements in the report. Because the complaint offered no motive for KPMG to make false statements and was premised on a theory of recklessness, the court said that the strength of the circumstantial allegations had to be correspondingly greater.

The court said that events alleged in the complaint did not give rise to a strong inference of scienter and did not produce a plausible claim that KPMG acted in a highly unreasonable manner that represented an extreme departure from the standard of ordinary care when it issued its audit report.

The court said the events were more naturally viewed as evidence that KPMG was aware of the importance of confirming the existence of executed master agreements and signed field tickets.

The case is No. 13-cv-01213.

Attorneys: Jonathan Richard Horne (The Rosen Law Firm, P.A.) for Gerald Kolar. John F. Hartmann (Kirkland & Ellis LLP) for KPMG LLP.

Companies: KPMG LLP

MainStory: TopStory AccountingAuditing FraudManipulation NewYorkNews

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