Partial Dismissal of ZST

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LINKS: 47, 53, 57 UNITED STATES DISTRICT COURT CENTRAL DISTRICT OF CALIFORNIA CIVIL MINUTES - GENERAL
Case No.
Title
CV 11-03531 GAF (JCx) Robert Scott v. ZST Digital Networks, Inc. et al.
Date
February 14, 2012
Present: The Honorable Renee Fisher Deputy Clerk
GARY ALLEN FEESS None Court Reporter / Recorder N/A Tape No.
Attorneys Present for Plaintiff : None Proceedings: (In Chambers)
Attorneys Present for Defendants: None
ORDER RE: MOTIONS TO DISMISS I. INTRODUCTION ZST Digital Networks, Inc., (ZST) is a Delaware corporation with its principal place of business in Henan Province, Peoples Republic of China (PRC) where its business operations include the development of digital and optical networking equipment supplied to local cable operators. ZST reports its annual financial results to both the SEC and to a PRC governmental agency, the State Administration of Industry and Commerce (SAIC). According to Plaintiffs, ZST reported financial results to the SEC indicating revenues over $50,000,000 in 2008 and over $100,000,000 in 2009, while reporting to the SAIC results that were a minuscule fraction of those figures. In this action, Plaintiff contends that the financial data submitted to the SEC was false and that ZSTs submissions violated numerous federal securities laws. Defendants now move to dismiss the complaint on the grounds that it fails to meet the requisite standard of particularity, and that the Lead Plaintiff lacks standing to assert claims under the Securities Act. For the reasons set forth below, the Court finds that the Exchange Act claims are adequately pleaded, but that Plaintiff has not properly alleged standing under the Securities Act. Accordingly, the motions are GRANTED in part and DENIED in part. II. BACKGROUND The action is brought on behalf of all persons who either [1] purchased or otherwise acquired ZST securities pursuant or traceable to the Companys Registration Statement issued in
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connection with its October 20, 2009 initial public offering of securities (IPO); or [2] purchased or otherwise acquired ZST securities from October 20, 2009 through April 21, 2011 (the Class Period), except for certain excluded persons and entities. (Docket No. 43, Consolidated Class Action Compl. (Compl.) at 1.) The complaint alleges that Defendants violated Sections 11 and 15 of the Securities Act of 1933 (the Securities Act) and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the Exchange Act) by submitting to the Securities and Exchange Commission (SEC) financial reports that were materially false and misleading, and which omitted facts to conceal adverse material information about the business operations and future prospects of ZST . . . . (Id. 52) In deciding a motion to dismiss, the Court must accept all well-pleaded factual allegations in the complaint as true. Blake v. Dierdorff, 856 F.2d 1365, 1368 (9th Cir. 1988). During the Class Period ZST maintained two materially different sets of financial records, one for reporting financial results in China to the SAIC, and another for reporting financial results in the United States to the SEC. (Id. 1.) Because financial reports submitted to the SAIC, unlike those filed with the SEC, are not publicly available, the discrepancies between the two sets of records was not known to the investing public until April 21, 2011, when that fact was disclosed via a two-part Internet report entitled ZST Digital Networks Unfolded: A Mutual Fund Manager Seeks the Truth. (Id. 2, 49.) The report disclosed that ZST had reported revenue of over $55 million to the SEC in 2008, and revenue of only $20,000 to the SAIC for the same fiscal year, and that the Company had reported losses of $130,000 to the SAIC, rather than the $6 million profit reported to the SEC. (Id. 4.) ZSTs per share stock price immediately dropped from $4.36, the closing price on the day prior, April 20, to $2.68, the closing price on April 21. (Id. 5.) The disclosure of this information revealed that ZSTs Registration Statement, filed with the SEC in connection with the IPO, contained materially different financial reporting than statements filed by the Companys wholly-owned subsidiary, Zhengzhou ZST, to Chinas SAIC. (Id. 38-44.) According to Plaintiff, ZSTs annual SAIC reports were audited by Chinese certified accountants, and contained lengthy audit opinions verifying the veracity of the reports. (Id. 45.) Although one unaffiliated with the company must submit requests to the SAIC and pay certain fees to obtain such reports, Plaintiff alleges that they are readily available to a companys authorized agents, such as its auditors or underwriters. (Id. 48.) The complaint asserts that: [1] if ZSTs SEC reports were materially inaccurate, various defendants are liable under both the Securities Act and the Exchange Act for the material misstatements contained therein; [2] if ZSTs SAIC reports were inaccurate, various defendants
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are liable under the Securities Act for representing in the Registration Statement that its Chinese subsidiary had been and would continue to faithfully comply with all Chinese laws, and/or failing to disclose in the Registration Statement that the Company was submitting contradictory financial reports to the SAIC. (Id. 6, 56-57.) Plaintiff asserts four causes of action, under Sections 11 and 15 of the Securities Act, and Sections 10(b) and 20(a) of the Exchange Act. Plaintiff names a number of defendants, including ZST (the Issuer Defendant); several of the Companys executives and officers (the Individual Defendants), who allegedly signed various SEC filings containing the misstatements and/or omissions; Rodman and Renshaw, LLC and WestPark Capital, Inc., two investment banks which served as underwriters for the Companys IPO (the Underwriter Defendants); and the Companys outside accountant, Kempisty & Company, P.C., which audited the financial statements submitted to the SEC (Kempisty or the Auditor Defendant). (Id. 12-27.) Despite the Courts obligation to accept the truth of the facts asserted in the complaint, Defendants seek to blunt the force of the allegations by presenting evidence in support of the pending motions. Specifically, Defendants attach the Companys amendment to its 2010 10-K, which addresses to some extent the discrepancies between the SEC and SAIC reports, as well as the ongoing risks posed by the inaccuracies contained in the SAIC reports: Our annual inspection reports filed with the SAIC for our PRC operating subsidiary, Zhengzhou ZST, have not been in compliance with applicable PRC regulations, and this could subject us to fines, penalties, and/or revocation of our business license. As one of its primary functions, the PRC State Administration of Industry and Commerce, or SAIC, and its local branches are responsible for the annual inspection of the business licenses of PRC domestic companies and foreign invested enterprises established in China. In connection with its annual inspection, the SAIC or its local branch, as applicable, requires these companies to file an annual inspection report and to submit financial statements as supplemental documentation. ... The Enterprises Annual Inspection Regulations in the PRC stipulate that the SAIC's or its local branch's focus in its review of these financial reports shall be on payment and authenticity of a company's registered capital, as a primary factor of such company's legal existence and good standing. As a result, the filing of these financial reports with
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the SAIC is often viewed generally as an administrative function. The reports that we filed with the SAIC for Zhengzhou ZST for fiscal 2008 and 2009 contained financial information that is materially different from the financial statements in our SEC filings. In addition, Zhengzhou ZST was converted from a domestic company to a foreign-invested company in 2008; however, the local AIC did not require Zhengzhou ZST to provide audited reports when it conducted its annual inspections for 2010, 2009 and 2008. As such, our SAIC reports for 2010, 2009 and 2008 do not comply with the requirements under Notice 33. According to our PRC counsel, the relevant laws do not provide for consequences of failure to provide audited report in an annual inspection which a company has passed; however, it is required that the information provided in the annual inspection report be genuine and accurate. In the event a company has false statements or omissions in its reports, such company may be required to revise these reports to provide accurate information and may be subject to fines from RMB10,000 to RMB50,000 (approximately US$1,600 to US$7,800) per filed SAIC report; if the discrepancies are material, in some instances the company's business license may be revoked. Following the filing of the 2009 SAIC report, the Company enhanced the procedures it follows with regard to SAIC financial report filings, so that there would be no material differences with the financial statements filed with the SEC. We do not believe that the financial information contained in our 2010 SAIC report is materially different from the financial information contained in our audited SEC filings, and we do not anticipate that the financial information reported under both regulatory schemes will be materially different in the future. We believe that the likelihood of imposition of a penalty in connection with the 2010, 2009 and 2008 financial reports filed with the SAIC is low and, even if imposed, would be deemed immaterial. However, we cannot assure you that we will not be penalized or have our license revoked for not complying with Notice 33. If the local AIC takes any legal action against us for our non-compliance with such regulation, our financial conditions and results of operations may be adversely and materially affected. We and an increasing number of China-based companies listed on U.S. stock exchanges have become the subject of negative media reports that focus on differences between the financial information set forth in filings with the US SEC and filings with the PRC's SAIC. The financial information contained in our SAIC reports for fiscal 2008 and 2009 were materially different than our SEC
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filings, and we have, and may continue to be, subject to these types of negative reports, which have and may continue to adversely affect the price of our common stock. During the second half of 2010 and continuing into 2011, numerous media reports in the United States and elsewhere made negative claims or suggestions regarding China-based companies listed on U.S. stock exchanges, including claims and suggestions relating to the accuracy and completeness of such companies' financial information filed with the U.S. SEC. Many of these reports appear to have been based, at least in part, on differences between financial information set forth in a company's filings with the U.S. SEC and filings with the PRC's State Administration for Industry and Commerce (SAIC). As noted above, the SAIC reports for Zhengzhou ZST for fiscal 2009 and 2008 contained financial information that was materially different from the financial statements in our SEC filings. In connection with these material differences, we have been subject to these negative reports that have focused on such material differences, accompanied by allegations of fraud. We do not believe that the financial information contained in our 2010 SAIC report is materially different from the financial information contained in our audited SEC filings and we do not anticipate that the financial information reported under both regulatory schemes will be materially different in the future; however, we remain subject to additional negative media reports by short sellers or media who may publish negative claims or suggestions about us or our financial results, including claims focused on any differences between the financial information we disclose in our SAIC and SEC filings, which could negatively affect the price of our common stock. (Docket No. 58, Declaration of Stephen D. Hibbard (Hibbard Decl.), Ex. J [Amended 2010 10-K] at 9-10). Based on these facts among others, Defendants filed three separate motions to dismiss. (Defendant Kempisty (Docket No. 48, Kempisty-Mem.); the Underwriter Defendants (Docket No. 53, UW-Mem.); Defendant ZST (Docket No. 57, ZST-Mem.)). Plaintiff sought leave to file, and did file an omnibus opposition to the motions. (Docket No. 78, Opp.) The Court separately addresses the Exchange Act and Securities Act claims. Because it concludes that the discrepancies between the two public filings constitute sufficient pleading of both falsity and scienter, and that the issue of which set of reports is accurate is not properly
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resolved on a motion to dismiss, the Court DENIES the motions insofar as they are directed at the Exchange Act claims. However, the Court finds that Plaintiff has not properly established his standing to bring Securities Act claims, and therefore GRANTS the motions to the extent that they urge dismissal of the complaints first and second causes of action. III. DISCUSSION A. PLEADING STANDARDS UNDER FEDERAL RULES OF CIVIL PROCEDURE 12(B)(6) AND 9(B), AND THE PSLRA A complaint may be dismissed if it fails to state a claim upon which relief can be granted. See Fed. R. Civ. P. 12(b)(6). On a motion to dismiss under Rule 12(b)(6), a court must accept as true all factual allegations pleaded in the complaint, and construe them in the light most favorable to the nonmoving party. Cahill v. Liberty Mut. Ins. Co., 80 F.3d 336, 33738 (9th Cir. 1996) Dismissal under Federal Rule of Civil Procedure 12(b)(6) may be based on either (1) a lack of a cognizable legal theory, or (2) insufficient facts under a cognizable legal theory. SmileCare Dental Grp. v. Delta Dental Plan of Cal., Inc., 88 F.3d 780, 783 (9th Cir. 1996) (citing Robertson v. Dean Witter Reynolds, Inc., 749 F.2d 530, 534 (9th Cir. 1984)). Under Federal Rule of Civil Procedure 8(a)(2), a complaint must contain a short and plain statement of the claim showing that the pleader is entitled to relief. Fed. R. Civ. P. 8(a)(2). The Supreme Court has interpreted this rule to allow a complaint to survive a motion to dismiss only if it contain[s] sufficient factual matter, accepted as true, to state a claim to relief that is plausible on its face. Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949 (2009) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)). A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged. Id. (citing Twombly, 550 U.S. at 556). [W]here the well-pleaded facts do not permit the court to infer more than the mere possibility of misconduct, the complaint has not sufficiently established that the pleader is entitled to relief. Id. at 1950. While a complaint generally need not contain detailed factual allegations, a plaintiffs obligation to provide the grounds of his entitlement to relief requires more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do. Twombly, 550 U.S. at 555 (citation, alteration, and internal quotation marks omitted). Similarly, a court need not accept as true allegations that are merely conclusory, unwarranted deductions of fact, or unreasonable inferences. Sprewell v. Golden State Warriors, 266 F.3d 979, 988 (9th Cir. 2001). In other words, the tenet that a court must accept as true all of the allegations
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contained in a complaint is inapplicable to legal conclusions. . . . While legal conclusions can provide the framework of a complaint, they must be supported by factual allegations. Iqbal, 129 S. Ct. at 194950. Moreover, Federal Rule of Civil Procedure 9(b) imposes heightened pleading requirements for claims of fraud. See Fed. R. Civ. P. 9(b). Under Rule 9(b), a plaintiff must state with particularity the circumstances constituting fraud, but can allege generally [m]alice, intent, knowledge, and other conditions of a persons mind. Id. The particularity requirement has been interpreted to mean the pleader must state the time, place and specific content of the false representations as well as the identities of the parties to the misrepresentation. Miscellaneous Serv. Workers, Drivers & Helpers, Teamsters Local No. 427 v. Philco-Ford Corp., 661 F.2d 776, 782 (9th Cir. 1981). Further, where there are multiple defendants, Rule 9(b) does not allow a complaint to . . . lump multiple defendants together but require[s] plaintiffs to differentiate their allegations when suing more than one defendant. Destfino v. Reiswig, 630 F.3d 952, 958 (9th Cir. 2011) (citation and internal quotation marks omitted). In addition, the plaintiff must set forth what is false or misleading about a statement, and why it is false. Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156, 1161 (9th Cir. 2009) (internal quotations omitted). These requirements ensure . . . that allegations of fraud are specific enough to give defendants notice of the particular misconduct which is alleged to constitute the fraud charged so that they can defend against the charge and not just deny that they have done anything wrong. Semegen v. Weidner, 780 F.2d 727, 731 (9th Cir. 1985). Beyond the requirements of Fed. R. Civ. P. 12(b)(6) and 9(b), the PSLRA establishes even higher pleading standards a plaintiff must meet when alleging a securities fraud cause of action. These requirements pertain largely to the scienter and falsity inquiries, which the Court addresses below. B. EXCHANGE ACT CLAIMS The bulk of the parties argument centers on Plaintiffs first and third causes of action, under Section 11 of the Securities Act and Section 10(b) of the Exchange Act, respectively. Plaintiffs second and fourth causes of action, under Section 15 of the Securities Act and Section 20(a) of the Exchange Act, are both control claims, which are largely derivative of and depend on primary violations of the respective Acts. The Court first addresses the Exchange Act claims, and then turns to Plaintiffs Securities Act claims. Plaintiffs third cause of action alleges that Defendants ZST and Kempisty violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder. (Compl.
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117128.) Plaintiff alleges that during the Class Period, Defendants carried out a plan, scheme, and course of conduct which was intended to and, through the Class Period, did: [1] deceive the investing public, including Lead Plaintiff and other Class members . . . ; and [2] caused Lead Plaintiff and other members of the Class to purchase ZST securities at artificially inflated prices. (Id. 119.) Moreover, Plaintiff alleges that Kempisty, in furtherance of that fraudulent scheme, audited and approved ZSTs financial statements despite knowing or deliberately disregarding the fact that they were materially false and misleading. (Id. 120.) The complaint alleges that the Defendants made untrue statements of material fact or omitted to state material facts necessary to make the statements not misleading, despite having possession of material adverse non-public information which contradicted those statements and public information about the business, operations, and future prospects of ZST . . . . (Id. 121122.) Unlike the claims brought under the Securities Act, Plaintiff relies solely on his first theory of liability in pleading his Section 10(b) claim, namely that ZSTs financial reports submitted to the SEC were materially inaccurate, and that Defendants are therefore liable for materially misstating the financial information contained therein. (Id. 6.) Plaintiff and other members of the Class, according to the complaint, were ignorant of the fact that market prices of ZSTs publicly traded securities were artificially inflated, and relied directly and/or indirectly on the false and misleading statements made by Defendants, or upon the integrity of the market in which ZSTs stock trades. (Id. 125.) As a direct and proximate result of that conduct, Plaintiff alleges that he and other members of the Class suffered damages in connection with their purchase of the Companys securities. To state a claim under Section 10(b) of the Exchange Act, a plaintiff must allege and adequately plead (1) a material misstatement or omission; (2) scienter; (3) connection with the purchase or sale of a security; (4) reliance; (5) proximate or loss causation; and (6) economic loss. Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 341 (2005). Defendants contend that Plaintiff has failed to adequately plead the first, second, fourth, and fifth such elements. 1. SCIENTER AND FALSITY To demonstrate scienter, the PSLRA requires that a plaintiff state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind in making misleading statements and/or omissions. 15 U.S.C. 78u-4(b)(2). Under this provision, the mental state required for securities fraud liability is distinct from the level of pleading required to infer that mental state. South Ferry LP, No. 2 v. Killinger, 542 F.3d 776, 782 (9th Cir. 2008) (quoting In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970, 975 (9th Cir. 1999)). A plaintiff must show that the defendant engaged in knowing or
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intentional conduct. South Ferry, 542 F.3d at 782. In the Ninth Circuit, reckless conduct can almost meet this standard to the extent that it reflects some degree of intentional or conscious misconduct, or what [courts] have called deliberate recklessness. Id. (citing Silicon Graphics, 182 F.3d at 977) (quotation marks omitted). Thus, in sum, a complaint must state with particularity facts giving rise to a strong inference of deliberate recklessness in order to satisfy the PSLRAs pleading requirements for scienter. The Supreme Court has held that this strong inference must be cogent and compelling, [and] thus strong in light of other explanations. Tellabs, Inc. v. Makor Issues and Rights, Ltd., 551 U.S. 308, 324 (2007). The reviewing court must ask, when the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter a least as strong as any opposing inference? Id. at 326. In other words, [a] court must compare the malicious and innocent inferences cognizable from the facts pled in the complaint, and only allow the complaint to survive a motion to dismiss if the malicious inference is at least as compelling as any opposing innocent inference. Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 991 (9th Cir. 2009). The court must determine whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard. Id. (quoting Tellabs, 551 U.S. at 323); see also South Ferry, 542 F.3d at 784 (The Supreme Court's reasoning in Tellabs permits a series of less precise allegations to be read together to meet the PSLRA requirement.) Moreover, with respect to falsity, the complaint must specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed. 15 U.S.C. 78u-4(b)(1). The scienter and falsity inquiries overlap significantly. In Ronconi v. Larkin, the Ninth Circuit explained that: Because falsity and scienter in private securities fraud cases are generally strongly inferred from the same set of facts, we have incorporated the dual pleading requirements of 15 U.S.C. 78u-4(b)(1) and (b)(2) into a single inquiry. In considering whether a private securities fraud complaint can survive dismissal under Rule 12(b)(6), we must determine whether particular facts in the complaint, taken as a whole, raise a strong inference that defendants intentionally or with deliberate recklessness' made false or misleading statements to investors. 253 F.3d 423, 429 (9th Cir. 2001) (quoting Silicon Graphics, 183 F.3d at 979). The Ninth
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Circuit recently re-iterated that falsity may itself be indicative of scienter where it is combined with allegations regarding a management's role in the company that are particular and suggest that the defendant had actual access to the disputed information, and where the nature of the relevant fact is of such prominence that it would be absurd to suggest that management was without knowledge of the matter. Zucco Partners, 552 F.3d 981 at 1000 (quotation marks and citation omitted) (quoting South Ferry, 542 F.3d at 785). a. Representations in SEC Reports As ZST notes in its motion, Plaintiff premises his first theory of liability solely on the discrepancies between the Companys 2008 and 2009 SAIC and SEC filings. (ZST-Mem. at 12.) It is true, as Defendants repeatedly point out, that the complaint contains no particularized allegations supporting the notion that it was the SEC filings, as opposed to the SAIC filings, which misstated the companys financial information, nor any company-specific facts concerning ZSTs sales or accounting practices. Nevertheless, the Court finds that the marked disparity between the revenue figures reported to American and Chinese regulatory bodies, along with the Companys subsequent and ambiguous explanation of those discrepancies, the strong inference that the Chinese statement reflected an overstatement in revenues reported to the SEC are sufficient to constitute falsity and scienter under the PSLRA. The Court therefore finds that Plaintiff has adequately pleaded a strong inference of scienter based on the alleged falsity of the revenue figures provided in the SEC reports. Defendants articulation of an alternative reading of the facts pleaded in the complaint, namely the explanation offered in the Companys amended 10-K and in its briefing, is apparently an effort, through evidence outside the pleadings, to bring this case within the Supreme Courts Tellabs inquiry. Even taking that evidence into consideration, the Court is not persuaded that the Exchange Act claims should be dismissed. As noted above, the Tellabs inquiry entails a compar[ison] [of] the malicious and innocent inferences cognizable from the facts pled in the complaint, under which the complaint survives a 12(b)(6) motion only if a reasonable person [would] deem the inference of scienter at least as strong as any opposing inference. Zucco, 552 F.3d at 991; Tellabs, 551 U.S. at 326. On the basis of the record before it, the Court cannot conclude that Defendants reading of the facts is any more compelling than that which is drawn by Plaintiffs allegations. The Companys reported revenue to the SEC and to the SAIC differ by a factor of over two thousand, and the Companys reported profit of $6 million to American regulatory authorities is entirely inconsistent with its report of a loss in China. Although ZST sought to explain these discrepancies in its amended 2010 10-K, the proffered explanation merely dances around the
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issue, noting the existence of a discrepancy without explaining how the company came to report such dramatically different results to the two different governmental agencies. Rather, the amended 10-K merely states that, because the reports are related to the companys legal existence and good standing, they are viewed generally as an administrative function, and because the local administrative body did not require audited reports, the Companys submissions did not comply with Chinese regulations. (Hibbard Decl., Ex. J [Amended 2010 10-K] at 9-10.) That explanation does not even begin to rebut Plaintiffs allegation that the SEC reports were false, as even if the reports were merely administrative, and even if they were not audited, the vast divergence between the numbers are not explained by a lack of outside review or even a haphazard preparation. As Plaintiff notes, one set of numbers showed a highly successful and profitable company; the other showed a poorly performing company struggling to make a profit. (Opp. at 1.) Moreover, Plaintiff avers in his complaint that the Chinese reports were indeed audited, which amounts to an allegation that ZST made misstatements not only in its original filings, but also in its amended filings intended to correct the prior inaccuracies. (Compl. 45.) In short, Defendants have done nothing other than cite to an ambiguous explanation offered in the Companys amended 10-K, one which Plaintiff alleges not only fails to correct prior misstatements, but also makes additional false representations. That alone cannot insulate ZST from liability, nor is it sufficient to dismiss a complaint alleging that previously filed reports contained blatant and fraudulent misrepresentations of the Companys financial health.1 Other courts addressing this very issue have reached the same conclusion. See, e.g., In re China Education Alliance, Inc. Securities Litigation, No. 10:09239-CAS, Docket No. 61 (C.D. Cal. Oct. 11, 2011) (sustaining similar claims based on allegations that defendant ha[d] filed significantly disparate revenue figures in China and the United States, and that company engaged in other suspicious behavior); Katz v. China Century Dragon Media, Inc. et al., 2011 WL 6047093, at *4 (C.D. Cal. Nov. 30, 2011) (holding that, with respect to falsity, a plaintiff must plead not only that revenue numbers contained in SEC and SAIC reports differed, but also that Chinese and American accounting standards are sufficiently similar such that the . . . numbers should be substantially the same . . . .) As noted above, Plaintiff has alleged both that Defendants filed disparate revenue figures in China and the United States, and that the Company
Similarly, it would be difficult to conclude that the alleged misstatements were not material, as they certainly would have been viewed by the reasonable investor as having significantly altered the total mix of information available. Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1318 (2011).
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subsequently made further misstatements in seeking to explain these differences.2 Moreover, Plaintiff specifically alleges in the complaint that [a]lthough there is some disparity between Chinese accounting methodology and U.S. accounting standards, these deviations cannot rationally explain the incredible differences of magnitude between the numbers reported in China and those reported in ZSTs SEC filings. (Compl. 45.)3
Defendants contend that the signing of the Registration Statement and certification of Sarbanes-Oxley documentation does not itself demonstrate scienter. Until recently, the Ninth Circuit adhered to a general rule finding inadequate complaints alleging that facts critical to a business's core operations or an important transaction generally are so apparent that their knowledge may be attributed to the company and its key officers. Zucco, 552 F.3d at 1000. In South Ferry, however, the Court of Appeals explained that such allegations are only one factor in a Tellabs inquiry: In summary, allegations regarding management's role in a company may be relevant and help to satisfy the PSLRA scienter requirement in three circumstances. First, the allegations may be used in any form along with other allegations that, when read together, raise an inference of scienter that is cogent and compelling, thus strong in light of other explanations. Tellabs. This view takes such allegations into account when evaluating all circumstances together. Second, such allegations may independently satisfy the PSLRA where they are particular and suggest that defendants had actual access to the disputed information, as in Daou and Oracle. Finally, such allegations may conceivably satisfy the PSLRA standard in a more bare form, without accompanying particularized allegations, in rare circumstances where the nature of the relevant fact is of such prominence that it would be absurd to suggest that management was without knowledge of the matter. 542 F.3d at 785-786. To the extent that such allegations are relevant to the Tellabs inquiry, the Court finds that the Individual Defendants signatures certifying the Companys financial statements, along with the critical importance of the financial information being certified, support a finding of scienter. See, e.g., In re Medicis Pharmaceutical Corp. Securities Litigation, 2010 WL 3154863, at *5 (D. Ariz. 2010) (Accounting errors that prove to have a significant impact on core business operations, i.e. cash, revenue, profits, liquidity, or viability of a product, sometimes give rise to a compelling inference of scienter. This is so because such substantial errors give rise to an inference that the defendant acted recklessly or intentionally used deceptive accounting principles to disguise serious problems.) (internal citations omitted). Although Defendants emphasize Plaintiffs failure to offer motive evidence, such as sales of stock by the Individual Defendants, the Supreme Court has recently held that: While it is true that motive can be a relevant consideration, and personal financial gain may weigh heavily in favor of a scienter inference, we agree with the Seventh Circuit that the absence of a motive allegation is not fatal. As earlier stated, allegations must be considered collectively; the significance that can be ascribed to an allegation of motive, or lack thereof, depends on the entirety of the complaint. Tellabs, 551 U.S. at 325 (citations omitted).
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2. AUDITOR LIABILITY Defendant Kempisty, ZSTs outside auditor, moves separately to be dismissed from the Exchange Act claims. The Court finds that Plaintiff has not adequately pleaded falsity and scienter with respect to Kempisty. Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b5, assuming all of the requirements for primary liability under Rule 10b5 are met. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994). See also McGann v. Ernst & Young, 102 F.3d 390 (9th Cir. 1996). Plaintiff alleges that Kempisty made false statements in an audit opinion attached to the Companys SEC filings, in particular when it represented that [w]e have audited the accompanying consolidated balance sheets of ZST Digital Networks, Inc. . . . In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ZST Digital Networks, Inc. . . . . (Compl. 64.) However, Plaintiffs allegations that Kempisty was an experienced auditor of Chinese issuers financials, and must have been aware of the existence of the SAIC filings, a mere glance [at which] would have readily lead to the discovery of the discrepancies, is insufficient to constitute the reckless indifference required by the case law. See New Mexico Inv. Council v. Ernst & Young LLP, 641 F.3d 1089, 1095 (9th Cir. 2011) ([T]he more likely an auditor would have discovered the truth if a reasonable audit had been conducted, the stronger the scienter inference.) In New Mexico, the Ninth Circuit reiterated that [t]ypically, pleading sufficient facts to support a strong inference of scienter by an outside auditor is difficult because outsider auditors have more limited information than, for example, the company executives who oversee the audit. Id. at 1098. The Court of Appeals elaborated on the standard a court should apply to such allegations: In examining allegations of scienter, courts have looked at a range of factors for potential red flags, including the interaction of auditors with company executives and the breadth and scope of the auditor's deviation from GAAP or GAAS. The red flag doctrine guides the GAAP and GAAS inquiries: the more facts alleged that should cause a reasonable auditor to investigate further before making a
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representation, the more cogent and compelling a scienter inference becomes. Scienter requires more than a misapplication of accounting principles. The plaintiff must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. Id. (internal citations omitted). Plaintiff has not alleged that Kempisty had any knowledge of the existence of the SAIC reports, nor that it ignored their divergent revenue figures, nor that being ignorant of their existence constituted an egregious refusal to see the obvious, or to investigate the doubtful. Rather, the allegations against the Companys outside auditor are entirely derivative of the allegations against ZST and its executives. Accordingly, its motion is GRANTED and Plaintiffs claim under Section 10(b) is DISMISSED with leave to amend as against Kempisty. 3. LOSS CAUSATION Defendants also contend that Plaintiff has failed to adequately plead loss causation, because the existence of differences between the Companys SAIC and SEC filings were not revealed for the first time in the article posted on seekingalpha.com in April 2011 by the Second Short Seller, but were revealed nearly six months earlier in the article posted on that very same website by the First Short Seller. (ZST-Mem. at 19.) Loss causation is defined as a causal connection between the material misrepresentation and the loss. Dura Pharmaceuticals, 544 U.S. at 341. The Ninth Circuit has recently held that, at the pleading stage, a plaintiff must provide the defendant with only some indication that the drop in [the defendants] stock price was causally related to [its] financial misstatements. In re Daou Systems, Inc., 411 F.3d 1006, 1026 (9th Cir. 2005) (citing Dura Pharmaceuticals, 544 U.S. at 347 (requiring a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind). Defendants citation to a previous article containing allegations of wrongful behavior at the Company cannot overcome the Plaintiffs pleading of loss causation. Plaintiff alleges that ZSTs stock price fell precipitously over forty percent on April 21, 2011, the same day the purported article allegedly alerted the market to the existence of disparate sets of accounting reports. (Compl. 88.) Accordingly, the Court finds that the Plaintiff has given Defendants
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more than some indication as to the causal mechanism which is alleged to connect the purported revelation and the drop in the Companys share price. 4. RELIANCE Similarly, Defendants contend that Plaintiff has not adequately pleaded that he relied on the alleged misstatements, because the information which the Defendants were alleged to have withheld from or misrepresented to the market had been previously disclosed through other channels, namely the prior article discussed above. (ZST-Mem. at 16-17.) To claim a fraud-on-the-market presumption, as Plaintiff has here, one must establish: [1] that the defendant made public misrepresentations; [2] that the misrepresentations were material; [3] that the shares were traded on an efficient market; . . . and [4] that the plaintiff traded the shares between the time the misrepresentations were made and the time the truth was revealed. Basic Inc. v. Levinson, 485 U.S. 224, 248 (1988). Notwithstanding Plaintiffs pleading of these elements, Defendants rely on the truth-on-the-market defense, which requires them to show that the information alleged to have been withheld or misrepresented was transmitted to the public with a degree of intensity and credibility sufficient to effectively counterbalance any misleading impression created by [an] insider's one-sided representations. Provenz v. Miller, 102 F.3d 1478, 149293 (9th Cir.1996). As a general rule, however, the truth-on-the-market defense is intensely fact-specific, so courts rarely dismiss a complaint on this basis. Nguyen v. Radient Pharmaceuticals Corp., 2011 WL 5041959, at *7 (C.D. Cal. Oct. 20, 2011) (citing In re Amgen Inc. Securities Litigation, 544 F.Supp.2d 1009 (C.D. Cal. 2008)). In light of the markets non-reaction to the previous article a drop in the Companys share price of one percent, according to Plaintiff and its vigorous reaction to the publication of the April 21, 2011 article, the Court concludes that the issue is not appropriate for resolution at the pleading stage. The Court cannot say at this time that the relevant information had been transmitted with the requisite degree of intensity and credibility prior to April 21. 5. CONCLUSION RE: EXCHANGE ACT CLAIMS As to Plaintiffs third and fourth causes of action, Defendant ZSTs motion to dismiss is DENIED. The motion of Defendant Kempisty urging dismissal of the same claims is GRANTED. Plaintiff will, however, have an opportunity to amend his complaint in order to adequately plead these claims against Kempisty. C. SECURITIES ACT CLAIMS
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Plaintiffs first cause of action is asserted under Section 11 of the Securities Act, against all Defendants except for Defendants Chen and Na. (Compl. 61.) Plaintiff alleges that all such Defendants are liable for misstatements and/or omissions contained in the Registration Statement because [1] the Individual Defendants, except for Defendants Chen and Na, signed the Statement and, as directors and officers of ZST, and controlling persons of the issuer, owed to the holders of ZST Securities obtained through the Registration Statement the duty to make a reasonable and diligent investigation of the statements contained within it; [2] the Underwriter Defendants and Kempisty owed the same duty, and as agents of ZST had ready access to the Companys filings with the SAIC, and failed to ensure that its SAIC filings were included or referenced in the Registration Statement. (Id. 63-65.) Section 11 of the Securities Act of 1933 provides a cause of action against issuers, underwriters, auditors and all persons signing a registration statement that contain[s] an untrue statement of a material fact or omit[s] to state a material fact required to be stated therein or necessary to make the statements therein not misleading. 15 U.S.C. 77k(a). That section was designed to assure compliance with the disclosure provisions of the Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering. Herman & MacLean v. Huddleston, 459 U.S. 375, 381 (1983). Accordingly, to establish a prima facie case under Section 11, a plaintiff need only show a material misstatement or omission. Id.; see also Daou, 411 F.3d at 1027 (The plaintiff in a [Section 11] claim must demonstrate (1) that the registration statement contained an omission or misrepresentation, and (2) that the omission or misrepresentation was material, that is, it would have misled a reasonable investor about the nature of his or her investment.) (citations omitted). The plaintiff need not demonstrate scienter, reliance, or loss causation. Id. Although [S]ection 11 does not contain an element of fraud, a plaintiff may nonetheless be subject to Rule 9(b)'s particularity mandate if his complaint sounds in fraud. Daou, 411 F.3d at 1027. Defendants contend that Plaintiffs Section 11 claim fails on numerous grounds. Because the Court concludes that Plaintiff has not alleged sufficient facts demonstrating that he has standing to sue under Section 11, it does not address Defendants alternative arguments for dismissal. 1. TRACEABILITY AND STANDING Defendants contend that Lead Plaintiff Gray has failed to adequately plead that his shares were issued pursuant to or are traceable to the applicable Registration Statement, as required by 15 U.S.C. 77k(a).
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To have standing to bring suit under Section 11, a plaintiff must have purchased stock in the offering at issue, or trace later-purchased stock back to that offering. Plichta v. SunPower Corp., 790 F.Supp.2d 1012, 1022 (N.D. Cal. 2011) (citing Hertzberg v. Dignity Partners, Inc., 191 F.3d 1076, 1080 n. 4 (9th Cir. 1999)). District courts in this circuit addressing the issue have uniformly held that mere boilerplate allegations of traceability are insufficient to establish such standing. See, e.g., Plichta, 790 F.Supp.2d at 1022-1023 (Plaintiffs have not explained, however, how even with discovery, they hope to be able to prove that any of their shares are traceable to the original offering, given that the shares are fungible and that millions of shares were already being traded on the open market at the time of the offering.); In re Century Aluminum Co. Securities Litigation, 749 F.Supp.2d 964 (N.D. Cal. 2010) (Plaintiffs have neither alleged in the FAC, nor have they articulated in their oppositions, how to trace any particular shares in the 75 million share pool that existed after the secondary offering to show that those shares came from the secondary offering.) In In re STEC Inc. Securities Litigation, a district court in this District noted the language used in cases such as Plichta and Century Aluminum, and held that, under the relevant case law, a plaintiff need not plead facts that prove their securities are traceable to the secondary offering, but [must] plead facts showing that their shares can be traced. 2011 WL 2669217, at *14 (C.D. Cal. 2011).4 That interpretation accords with the Ninth Circuits own discussion of the issue in Hertzberg, where the Court of Appeals explained that: The limitation on any person is that he or she must have purchased such security. Clearly, this limitation only means that the person must have purchased a security issued under that, rather than some other, registration statement. While it might present a problem of proof in a case in which stock was issued under more than one registration statement, the only Dignity stock ever sold to the public was pursuant to the allegedly misleading registration statement at issue in this case. 191 F.3d 1076, 1080 (internal citation omitted). At least one court in this District has been more liberal in construing Section 11's standing requirement. See In re SeeBeyond Technologies Corp. Securities Litigation, 266 F.Supp.2d 1150, 1171-1172 (C.D. Cal. 2003) (finding allegation that a plaintiff purchased [the defendants] common stock issued pursuant to the registration statement/prospectus filed by the Company with the SEC sufficient to establish Section 11 standing at the pleading stage).
The court nevertheless agree[d] with the Century Aluminum analysis and the conclusion that postTwombly and Iqbal, Plaintiffs do not adequately allege standing simply by stating they purchased shares traceable to the Registration Statement and Prospectus. 2011 WL 2669217, at *14.
4
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Defendants note the existence of a second registration of ZSTs securities on January 14, 2010, before Lead Plaintiff Gray purchased his shares. According to the certification offered by Gray, his shares were purchased on March 3, 2011 and March 11, 2011, fifteen months after the original IPO and thirteen months after the second registration. (Docket No. 11, Declaration of Michael Goldberg (Goldberg Decl.), Ex. C [Shareholder Certification].) In opposition, Plaintiff avers that, as of August 2011 after the Class Period none of the shares issued in the second registration had sold into any public market. (Opp. at 19.) Plaintiff cites a 10-K filed by the company on August 2, 2011, which states that in January 2010, we registered 1,086,400 shares of common stock held by affiliates of WestPark, all of which may be freely sold and transferred. (Hibbard Decl., Ex. J [Amended 2010 10-K.].) Plaintiff focuses on that filings use of the word may, arguing that the mere fact of registration of these additional shares does not raise the possibility that Lead Plaintiffs publicly purchased shares could be traceable to any Registration Statement other than the one at issue in this action. (Opp. at 20.) However, Defendants note in reply that shares registered in the second Registration Statement had indeed been sold in the public market by the time Gray bought his shares in March 2011. (Docket No. 85, UW-Rep. at 6-7.) Moreover, an argument similar to Plaintiffs, as Defendants note, was recently rejected by a court in this District. Katz, 2011 WL 6047093, at *5 (Although Plaintiffs suggest that Katz and Shapiro must have bought in the IPO, because a planned resale of shares released under a private placement agreement did not occur, Plaintiffs allegations do not rule out the possibility that Katz and Shapiro purchased their shares in a manner not traceable to the IPO. Thus, Plaintiffs must plead with more specificity that Katz and Shapiro purchased their shares in a manner traceable to the IPO.) The Court finds that, as currently pleaded, the complaint cannot satisfy Section 11's standing requirements. Plaintiff has alleged only that he purchased ZST securities at artificially inflated prices during the Class Period and has been damaged thereby, and brings suit on behalf of persons who acquired shares of ZST Securities pursuant or traceable to the Registration Statement in connection with the IPO. (Compl. 11, 29, 61.) Even under the more liberal pleading standard articulated in SeeBeyond, those allegations are insufficient. 266 F.Supp.2d at 1171-1172; see also Katz, 2011 WL 6047093, at *5 (distinguishing between particular allegation that plaintiff purchased shares during the IPO, and generalized allegations that [e]ach Class Member acquired his, her, or its shares in, pursuant to and/or traceable to, and in reliance on, the Registration Statement and Prospectus, and finding the latter insufficient). Plaintiff need not plead facts proving that his shares are traceable to the Registration Statement in question, but [must] plead facts showing that [his] shares can be traced. STEC Inc., 2011 WL 2669217, at *14.
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Because the Court finds that Gray lacks standing under Section 11, that claim, along with his claim under Section 15 of the Securities Act, must be DISMISSED. Plaintiff will, however, have an opportunity to amend his complaint in order to adequately plead that the shares were purchased in the offering at issue, or can be traced back to that offering. Until Plaintiff does so, the Court need not address Defendants various other grounds for dismissal of his Section 11 claims. IV. CONCLUSION For the reasons set forth above, the motions are GRANTED in part and DENIED in part. Plaintiffs first and second claims, for violations of Sections 11 and 15 of the Securities Act, are DISMISSED with leave to amend. Plaintiffs claims for violations of Sections 10(b) and 20(a) of the Exchange Act are DISMISSED with leave to amend as against Defendant Kempisty. In all other respects, Defendants motions are DENIED. Failure to file an amended complaint curing the deficiencies outlined above by March 9, 2012 will be deemed consent to dismissal of the claims with prejudice.
IT IS SO ORDERED.
CV-90 (06/04)
CIVIL MINUTES - GENERAL
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Partial Dismissal of ZST

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Case 2:11-cv-03701-DMG-MRW Document 75-1 #:1159

Filed 02/16/12 Page 1 of 20 Page ID

February 14, 2012

Present: The Honorable Renee Fisher Deputy Clerk

Attorneys Present for Plaintiff : None Proceedings: (In Chambers)

Attorneys Present for Defendants: None

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CIVIL MINUTES - GENERAL

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