Miller Investment Trust v. Morgan Stanley & Co. Incorporated

UNITED STATES DISTRICT COURT

DISTRICT OF MASSACHUSETTS

MILLER INVESTMENT TRUST and )

JURA LIMITED, )

)

Plaintiffs, )

) CIVIL ACTION NO.

) 11-12126-DPW

v. )

)

)

MORGAN STANLEY & CO., LLC and )

KPMG HONG KONG, )

)

Defendants. )

MEMORANDUM AND ORDER

March 30, 2018

TABLE OF CONTENTS

I. FACTUAL BACKGROUND.......................................... 4

A. Shengda’s Note Offering and the Plaintiffs’ Purchases .... 4

B. KPMG-HK’s Realization of Shengda’s Overvaluation and ......

Shengda’s Bankruptcy ......................................... 6

C. Alleged Misrepresentations by KPMG-HK .................... 9

D. Impact of Misrepresentations on the Plaintiffs .......... 11

II. PROCEDURAL HISTORY........................................ 12

III. STANDARD OF REVIEW....................................... 18

IV. DISCUSSION................................................ 20

A. Section 18 Claim ........................................ 20

1. Pleading Requirements ................................. 20

2. False or Misleading Statements ........................ 23

a. Conformance of KPMG-HK’s Audit of Shengda’s Financial .

Statements and Internal Controls with PCAOB Standards .... 29

i. Failure to Investigate False Statements About SSCM by .

Shengda’s CFO ....................................... 33

ii. Internal Control Deficiencies ...................... 43

iii. Failure to Establish Direct Contact in the .........

Confirmation Process .................................... 46

iv. Ignoring Red Flags ................................. 51

v. Alleged Violations After March 2010 ................. 55

vi. Import of the Magnitude of the Fraud and the East of .

its Discovery ...................................... 57

b. Conformance of Shengda’s Financial Statements with.....

GAAP ................................................ 59

c. Loss Causation ...................................... 66

B. Negligent Misrepresentation Claim ....................... 77

1. Pleading Requirements ................................. 77

2. False Information ..................................... 80

3. Justifiable Reliance .................................. 83

IV. CONCLUSION................................................ 88

Plaintiffs Miller Investment Trust (“Miller”) and Jura

Limited (“Jura”) seek to recover investment losses from

purchases of $8.7 million of bonds offered by ShengdaTech, Inc.

(“Shengda”) made between December 2010 and February 2011. In

March 2011, it was reported that Shengda had vastly overstated

its revenues. Shortly thereafter, Shengda defaulted and

declared bankruptcy. In December 2011, Miller brought this

action alleging securities fraud against Defendants Morgan

Stanley, which underwrote the offering, and KPMG Hong Kong

(“KPMG-HK”), Shengda’s auditor. The Plaintiffs allege that

Morgan Stanley and KPMG-HK knew or should have known about

misrepresentations of material fact made in the offering

documents provided to the Plaintiffs on which Plaintiffs relied

in deciding to purchase the Shengda bonds.

The instant motion to dismiss pertains only to those claims

asserted by Miller against KPMG-HK. Following several

iterations of the complaint, after each of which KPMG-HK has

moved to dismiss, now before me is KPMG-HK’s motion for

dismissal of the two counts against it set forth in the Third

Amended Complaint: negligent misrepresentation under state

common law and violation of § 18 of the Securities Exchange Act

of 1934, 15 U.S.C. § 78r.

I. FACTUAL BACKGROUND

I recount the facts as alleged in the Third Amended

Complaint as true, focusing primarily on those allegations

pertaining to KPMG-HK.

A. Shengda’s Note Offering and the Plaintiffs’ Purchases

Shengda was a Nevada corporation with its principal place

of business in the People’s Republic of China. Third Am. Compl.

(TAC) ¶ 37. Before its bankruptcy, Shengda primarily

manufactured a chemical additive called nano-precipitated

calcium carbonate, which is used to improve industrial materials

such as paint, paper, plastic, and rubber. Id. It conducted

its manufacturing operations through Chinese subsidiaries.1 Id.

¶¶ 34, 38.

In 2010, Shengda sold an aggregate of $130 million of 6.5%

senior convertible notes due in 2015 through a private placement

offering closing in December 2010. TAC ¶¶ 1, 16, 219, 224. In

connection with the offering, Morgan Stanley,2 the underwriter,

prepared a private placement memorandum (“PPM”) that would be

distributed to potential purchasers. Id. ¶¶ 2, 20, 23, 32, 33,

258. The PPM contained numerous financial documents relating to

1 Specifically, Shengda owned Faith Bloom Limited, a Singapore

corporation, which in turn owned five Chinese companies;

together, these companies were the sole source of Shengda’s

revenues. TAC ¶ 38.

2 Morgan Stanley is a global financial services firm with its

headquarters in New York. TAC ¶ 33.

Shengda, including its 2008 and 2009 SEC Form 10-Ks, each of

which contained an audit report from KPMG-HK for the respective

fiscal years 2008 and 2009. Id. ¶¶ 2, 34, 258. Shengda retained

KPMG-HK3 to serve as its independent auditor from November 2008

until April 2011, during which time KPMG-HK completed audits for

fiscal years 2008 and 2009, and partially completed an audit for

2010. Id. ¶¶ 34, 58.

After receiving additional assurances from KPMG-HK as to

the use of its audit reports and the accuracy of Shengda’s

financial statements, Morgan Stanley distributed the PPM to

potential buyers, including Wellesley Investment Advisors, Inc.

TAC ¶¶ 2, 23, 34, 220, 243, 258. Wellesley Investment Advisors

is a registered investment adviser in Massachusetts that manages

Miller, a mutual fund, and has full investment authority over

the funds of Jura, a Bermuda corporation. Id. ¶¶ 28, 30-31.

Relying on the information provided in the PPM and in Shengda’s

SEC filings, Miller purchased approximately $8 million of

Shengda bonds (Shengda’s 2015 Notes) between December 10, 2010

and February 16, 2011,4 id. ¶¶ 20-21, 29, 32, 243-244, from

3 KPMG-HK is a Hong Kong partnership that is a member of KPMG

International Cooperative. TAC ¶ 34.

4 After its initial purchase through the private placement of

$5,400,000 on December 10, 2010, Miller sold $310,000 and

$1,500,000 in Shengda bonds on December 21 and December 23,

2010, respectively. TAC ¶ 244(d)-(i). Thereafter, Miller

purchased $2,000,000 in Shengda bonds on January 21, 2011;

Morgan Stanley, through the private placement and four

subsequent transactions. Jura, through Wellesley Investment

Advisors, purchased $700,000 of Shengda convertible bonds in two

purchases on December 12, 2010 and February 27, 2011. Id. ¶¶ 30-

32, 243-245.

B. KPMG-HK’s Realization of Shengda’s Overvaluation and

Shengda’s Bankruptcy

In conducting its audit for Shengda for fiscal year 2010,

KPMG-HK conducted additional procedures that it had allegedly

assured the chair of Shengda’s Audit Committee it would perform.

TAC ¶¶ 17, 166. On March 1 and 2, 2011, KPMG-HK began

contacting Shengda’s customers, suppliers, and banks using

publicly available contact information, and learned that many of

Shengda’s claims regarding business relationships and financial

statements were false. Id. ¶¶ 17, 225-226. Specifically, KPMG-

HK “could not confirm sales amounts, sales terms, and

outstanding balances, discovered that many documents ShengdaTech

provided to KPMG were crude forgeries, discovered that certain

transactions had been with related parties without necessary

disclosure, and that suppliers and customers denied engaging in

business with ShengdaTech.” Id. ¶ 226. The Plaintiffs contend

that KPMG-HK would have discovered these issues earlier had it

$410,000 on February 4, 2011; $1,000,000 on February 11, 2011;

and $1,000,000 on February 16, 2011. Id. ¶ 244.

conducted its 2008 and 2009 audits consistent with governing

auditing standards. Id. ¶ 227.

Beginning on March 2, 2011, and through a series of three

memoranda thereafter, KPMG-HK informed Shengda’s Audit Committee

of its discovery of “potentially serious discrepancies and

unexplained issues” during its audit of Shengda’s financial

statements for fiscal year 2010. TAC ¶¶ 226-227. Shengda

immediately convened a special committee, composed of the

independent directors on the Audit Committee and advised by a

law firm and an accounting firm, to conduct an internal

investigation. Id. ¶¶ 228-229. On March 14, NASDAQ suspended

trading in Shengda’s equity securities, thereafter stating that

it would not resume trading until Shengda had “fully satisfied

NASDAQ’s request for additional information.” Id. ¶¶ 230, 232.

The next day, Shengda issued a press release announcing the

appointment of the special committee “to investigate potentially

serious discrepancies and unexplained issues relating to the

Company and its subsidiaries’ financial records.” Id. ¶ 231.

In April 2011, KPMG-HK resigned as Shengda’s auditor,

stating that it had “doubts about management’s representations

provided to [KPMG-HK] in connection with [its] 2008 and 2009

audits of the consolidated financial statements and the

effectiveness of internal control over financial reporting of

the Company.” TAC ¶ 233. KPMG-HK implored Shengda to make

disclosures regarding any errors in previously issued audit

reports to prevent future reliance on them. Id.

On May 5, Shengda filed a current report on Form 8-K with

the SEC, stating that “KPMG previously informed the Company’s

Audit Committee of certain concerns arising during its

incomplete audits of the Company’s consolidated financial

statements as of and for the year ended December 31, 2010, and

the effectiveness of internal control over financial reporting

as of December 31, 2010.” TAC ¶ 234. It went on to identify

issues related to bank balances, supplier transactions, VAT tax

invoices, third-party sales and payments, customer sales, and

the confirmation process. Id.

On June 9, Shengda announced that it was in default on the

convertible bond securities issued in the 2010 private

placement; the next day, all trading of Shengda stock was

suspended by NASDAQ. TAC ¶¶ 235-236. The SEC thereafter

commenced a regulatory proceeding resulting in an order noting

potential federal securities laws violations arising from false

statements made in the 2009 Form 10-K, the 2009 Form 10-K/A, and

the 2009 and 2010 Form 10-Qs. Id. ¶¶ 237, 239.

On August 19, Shengda filed a Chapter 11 bankruptcy

petition and an adversary proceeding against its Chief Executive

Officer, Ziangzhi Chen, to prevent him from interfering with the

restructuring.5 TAC ¶¶ 238, 240-241, 251. See In re

ShengdaTech, Inc., BK-11-52649 (D. Nev. Aug. 19, 2011, ECF No.

1); see also ShengdaTech, Inc. v. Chen, 11-05082-BTB (D. Nev.

Aug. 23, 2011, ECF No. 12). With this filing, the Plaintiffs’

notes became immediately due and payable by their terms. Id.

¶ 238. In bankruptcy, Shengda has been unable to satisfy the

vast majority of its liabilities. Id. ¶¶ 252-254.

C. Alleged Misrepresentations by KPMG-HK

The Plaintiffs allege that the offering documents in the

PPM on which they relied in purchasing the Shengda bonds

contained material misrepresentations that made Shengda appear

far more stable financially than it was. TAC ¶¶ 22, 26, 32, 61,

62. Further, they contend that KPMG-HK, as Shengda’s auditor

(and Morgan Stanley as Shengda’s underwriter), “had access to

ShengdaTech’s internal reports and other data and information

about those companies’ finances, operations and sales at all

relevant times,” and failed to perform its auditing

5 On September 2, 2011, the bankruptcy court found that Shengda’s

employees prevented the independent investigation from verifying

its cash accounts, that U.S. banks against which Shengda

allegedly held certificates of deposit did not have records of

issuance, and that Shengda had entered into undisclosed related-

party transactions. TAC ¶ 241. Approximately nine months

later, on June 20, 2012, Shengda filed its disclosure statement

to creditors, disclosing that many of its sales had been to

related parties owned by its CEO, and that those sales were

likely overstated. Id. ¶ 242.

responsibilities adequately, such that it would have discovered

Shengda’s fraud, in light of this information. Id. ¶¶ 6, 246.

Specifically, the Plaintiffs assert that KPMG-HK made two

materialy false statements:

First, regarding its own compliance with Public Company

Accounting Oversight Board (“PCAOB”) standards in auditing

Shengda’s financial statements; and

Second, regarding Shengda’s compliance with generally

accepted accounting principles (“GAAP”) in preparing its

financial statements. The Plaintiffs contend that KPMG-HK knew

or should have known that these statements were false. TAC

¶¶ 59-61.

KPMG-HK’s statement of PCAOB compliance appears in its

audit reports for fiscal years 2008 and 2009, dated March 31,

2009 and March 15, 2010, respectively, and in its internal

control audit report for fiscal year 2008, also dated March 31,

2009. TAC ¶¶ 34, 59-61; 2008 Audit Report; 2009 Audit Report;

2008 Internal Control Audit Report. KPMG-HK’s statement of GAAP

compliance also appears in its audit reports for fiscal years

2008 and 2009.6 TAC ¶¶ 59-60; 2008 Audit Report; 2009 Audit

6 The fiscal year 2008 report made this representation of GAAP

compliance “as of December 31, 2008”; the fiscal year 2009

report made this representation “as of December 31, 2009 and

2008.” TAC ¶¶ 59-60; 2008 Audit Report; 2009 Audit Report.

Report. These audit reports were incorporated into Shengda’s

2008 Form 10-K, filed April 1, 2009, and Shengda’s 2009 Form

10-K, filed March 15, 2010, respectively, and were included in

the PPM.7 TAC ¶ 34.

In addition, the Plaintiffs identify an allegedly false or

misleading statement in a comfort letter KPMG-HK provided to

Morgan Stanley in connection with the private placement, dated

December 9, 2010. TAC ¶¶ 34, 220. In that letter, KPMG-HK

consented to the use of its audit reports and its review of

Shengda’s 2010 quarterly financial statements in the PPM and

acknowledged that purchasers would rely on the opinions

expressed therein. Id. ¶¶ 34, 220. KPMG-HK also affirmed its

opinion as to the accuracy of Shengda’s 2010 quarterly financial

statements, noting that KPMG-HK did not believe that “any

material modifications should be made to the unaudited condensed

consolidated financial statements” included in the PPM “for them

to be in conformity with U.S. generally accepted accounting

principles.” Id. ¶¶ 221(a), 272.

D. Impact of Misrepresentations on the Plaintiffs

The Plaintiffs allege that they relied to their detriment

7 Although the Third Amended Complaint identifies numerous other

instances in which KPMG-HK consented to the use of its audit

reports in SEC filings in relation to an anticipated public

securities offering in 2010, the statements therein are not

actionable because the offering was never conducted. TAC

¶¶ 213-218.

on the misrepresentations and omissions of KPMG-HK and Morgan

Stanley in the documents that led the Plaintiffs to purchase the

Shengda notes. TAC ¶¶ 20-22, 26, 32. According to the

Plaintiffs, the materially false or misleading statements

created “an unrealistically positive assessment of ShengdaTech”

in the market, and this “fraudulently created” both a market for

and an overvaluing of the notes. Id. ¶¶ 22, 26, 32, 61-62, 247.

They contend that the notes “would never have come into the

market but for the fraud,” or, if they had, would have done so

with more favorable terms to investors, and that the Plaintiffs

would not have purchased the notes at all or on the terms they

did but for the misrepresentations of KPMG-HK and Morgan

Stanley. Id. ¶ 247.

The Plaintiffs further allege that immediately following

Shengda’s March 2011 press release stating that KPMG-HK had

encountered discrepancies in its 2010 audit, the Plaintiffs

sought to sell their convertible bonds, but the market had

become illiquid. Id. ¶¶ 248-250. As a result, having purchased

the bonds at or near par, and in many cases above par value, the

Plaintiffs “lost nearly their entire investment.” Id. ¶¶ 25,

231, 248-250, 255.

II. PROCEDURAL HISTORY

This case came to this session, having been before two

other judges in this district previously. The motion to dismiss

now before me follows a familiar pattern for motion to dismiss

practice in securities fraud litigation: successive motions to

amend the pleadings creating a moving target for an extended

period of time until the plaintiffs’ allegations come to rest

and can be examined by the court.

Miller filed its complaint on December 1, 2011, alleging

one count of violation of the Massachusetts Uniform Securities

Act, Mass. Gen. Laws. ch. 110A, § 410, against Morgan Stanley

and one count of negligent misrepresentation under state common

law against KPMG-HK. Compl. ¶¶ 1-3, 143-157. Morgan Stanley

filed a motion to dismiss the original complaint on January 31,

2012 for failure to state a claim. This was denied by Judge

Tauro. See Miller Inv. Trust v. Morgan Stanley & Co. Inc., 879

F. Supp. 2d 158 (D. Mass. 2012).8

8 Judge Tauro concluded that Miller had stated a claim against

Morgan Stanley under § 410(a)(2), because Miller specifically

alleged that “the Chinese and American accounting standards are

substantially similar on the issue of revenue recognition, that

Chinese penalties for failure to file accurate reports are more

likely to affect Chinese companies incorporated in the United

States than SEC penalties, and that ShengdaTech’s Chinese

subsidiaries were the sole source of its revenue.” See Miller

Inv. Trust v. Morgan Stanley & Co. Inc., 879 F. Supp. 2d 158,

166-67 (D. Mass. 2012) (citing Marram v. Kobrick Offshore Fund,

Ltd., 809 N.E.2d 1017 (Mass. 2004)). Judge Tauro also rejected

Morgan Stanley’s argument that the claim for purchases after the

initial offering should be dismissed, because “[w]hich, if any,

sales of securities resulted from the alleged misstatement

contained in the private placement memorandum is a question of

fact more appropriately determined at trial.” Id. at 167.

KPMG-HK filed its first motion to dismiss on June 7, 2012,

asserting insufficient service and failure to state a claim of

negligent misrepresentation under Fed. R. Civ. P. 8(a) or Fed.

R. Civ. P. 9(b).9 Before ruling on the motion to dismiss, and at

the joint request of Miller and KPMG-HK, Judge Tauro granted

Miller leave to file an Amended Complaint to add a claim against

KPMG-HK arising under § 18 of the Securities Exchange Act of

1934, 15 U.S.C. § 78r (the “Exchange Act”). The earlier motion

to dismiss was treated as superseded and KPMG-HK was given the

opportunity to file a new motion to dismiss.

Miller filed its first Amended Complaint on August 29,

2012, preserving the original two counts and adding a third

count for violation of § 18 of the Exchange Act by KPMG-HK.10

KPMG-HK thereafter filed a motion to dismiss for insufficient

service and inadequate pleading of both the § 18 claim and the

negligent misrepresentation claim. Judge Tauro provided Miller

with the opportunity to re-serve KPMG-HK in compliance with the

9 KPMG-HK asserted that Miller failed to comply with the Hague

Convention. KPMG-HK also asserted lack of personal

jurisdiction, and pursuant to the authorization of an earlier

pretrial order, Miller sought limited jurisdictional discovery.

KPMG-HK ultimately ceased pursuing the personal jurisdiction

defense.

10 Other than adding a few additional allegations regarding

jurisdiction over KPMG-HK for the federal question, and the

count for violation of § 18, the Amended Complaint did not make

substantive changes to the original complaint.

Hague Convention, in order to remedy the insufficient service of

KPMG-HK, and denied KPMG-HK’s motion to dismiss as moot.

Thereafter, in July 2013, KPMG-HK filed a renewed motion to

dismiss the Amended Complaint asserting inadequacy in the

pleadings. Miller moved for leave to file a Second Amended

Complaint, having provided notice of its intent to do so in

November 2013 in light of factual discovery it was obtaining in

another matter regarding the same underlying events.

Simultaneously, Jura moved to intervene as a plaintiff pursuant

to Fed. R. Civ. P. 24(b)(2) with respect to only count one

against Morgan Stanley. Judge O’Toole granted both the motion

for leave to amend and the motion to intervene, and dismissed

KPMG-HK’s pending motion to dismiss as moot in light of the

anticipated Second Amended Complaint, permitting KPMG-HK to file

a new motion to dismiss thereafter.

The Plaintiffs filed their Second Amended Complaint on

March 10, 2014.11 That complaint preserved the three counts in

the Amended Complaint and added Jura as a claimant in count one

only. Second Am. Compl. ¶¶ 245-265. In addition, the

11 Shortly after the filing of the Second Amended Complaint,

Miller and Jura filed a nearly identical complaint in the

District of Nevada against KPMG-HK alleging one count of

negligent misrepresentation. See Miller Inv. Trust v. KPMG,

3:14-cv-00133-LRH-VPC (D. Nev. Mar. 13, 2014). On January 8,

2015, that case was stayed upon the joint motion of the parties,

pending the resolution of this action.

reorganized Second Amended Complaint added fifty pages of new

allegations, derived largely from discovery in an action pursued

by the Plaintiffs against Shengda’s directors and officers in

the Southern District of New York and from a complaint filed by

Shengda’s liquidating trustee.12 Morgan Stanley dutifully filed

12 On June 26, 2012, Miller filed a complaint against the

president and directors of Shengda and against Hansen, Barnett &

Maxwell, P.C. (“Hansen”), a financial services firm that served

as Shengda’s auditor in 2007, alleging violation of Mass. Gen.

Laws ch. 110A, § 410(b); negligent misrepresentation under New

York law; negligent misrepresentation under Massachusetts law;

common law fraud; violation of Section 10(b) of the Exchange

Act, 15 U.S.C. § 78r, and Rule 10b-5, 17 C.F.R. 240.10b-5; and

violation of Section 20(a) of the Exchange Act, 15 U.S.C. § 78t.

See Miller Inv. Trust v. Xiangchi Chen, No. 1:12-cv-04997-LGS

(S.D.N.Y. June 26, 2012, ECF No. 1). That case has in many ways

paralleled this one procedurally, with a series of motions to

dismiss and motions to amend. Id. (S.D.N.Y. July 20, 2012, ECF

No. 6; Aug. 22, 2012, ECF No. 11; Jan. 15, 2013, ECF No. 20;

Feb. 6, 2013, ECF No. 21; Mar. 14, 2013, ECF No. 23).

Although Hansen filed a motion to dismiss in April 2013,

which typically would stay discovery under the Private

Securities Litigation Reform Act of 1995 (“PSLRA”), 15 U.S.C.

§ 78u-4(b)(3)(B), Judge Schofield concluded that the stay did

not apply to Hansen because it was subject only to a state

negligent misrepresentation claim, and ordered discovery to

proceed. Id. (May 21, 2013, ECF No. 39). Thereafter, Judge

Schofield granted Hansen’s motion to dismiss for lack of

personal jurisdiction. Id. (June 21, 2013, ECF No. 40).

Discovery then continued as to the defendants subject to federal

securities law claims. The parties reached a settlement

agreement prior to the completion of expert discovery, and the

action was dismissed without prejudice on October 22, 2014. Id.

(Oct. 22, 2014, ECF No. 110, 111). It is from the discovery

completed in the Chen case that the Plaintiffs here drew

additional allegations for their Second and Third Amended

Complaints.

Another lawsuit filed in June 2012 also bears noting.

Other investment managers and funds that had purchased bonds in

the 2008 and 2010 Shengda offerings brought suit in the District

of Nevada against Morgan Stanley, KPMG-HK, other KPMG entities,

an answer to the Second Amended Complaint, and KPMG-HK filed a

motion to dismiss, again alleging failure to plead adequately

both the § 18 claim and the negligent misrepresentation claim.

Following further briefing, the case was reassigned to this

session with KPMG-HK’s motion to dismiss still pending.

On January 15, 2015, the Plaintiffs filed yet another

motion to amend the complaint and for leave to file additional

allegations, which KPMG-HK opposed. After argument on both, I

granted Miller’s motion to amend and denied KPMG-HK’s motion to

and Hansen, alleging “that KPMG HK and Hansen failed to follow

generally accepted accounting standards (“GAAS”) in their audits

of Shengda’s financials, falsely stated that Shengda’s financial

statements complied with [GAAP]; and falsely opined that

Shengda’s ‘internal controls’ were sufficient.” Oaktree Capital

Mgmt., L.P. v. KPMG (Oaktree I), 963 F. Supp. 2d 1064, 1071-72

(D. Nev. 2013). The Plaintiffs also alleged that KPMG-HK

consented to the inclusion of these false statements in SEC

filings. Id. at 1072. Accordingly, the Plaintiffs alleged

violation of § 18 of the Exchange Act and negligent

misrepresentation under state common law by KPMG-HK.

On KPMG-HK’s motion to dismiss, Judge Mahan concluded that

the Plaintiffs had failed to state a claim under § 18 as to the

statements of GAAS and GAAP compliance, because the Plaintiffs

did not allege objective falsity sufficiently. Id. at 1085-86,

1090-91. Judge Mahan accordingly granted KPMG-HK’s motion to

dismiss, declining to exercise supplemental jurisdiction over

the remaining state law claims. Id. at 1091, 1092.

In a later ruling, Judge Mahan granted Hansen’s motion to

dismiss as well. See Oaktree Capital Mgmt., L.P. v. KPMG

(Oaktree II), No. 2:12-CV-956 JCM (GWF), 2014 WL 3816392, at *5

(D. Nev. Aug. 4, 2014). The Plaintiffs appealed that decision

to the Ninth Circuit, but the matter has since settled. See

id., appeal docketed sub nom. Oaktree Capital Mgmt., L.P. v.

Hansen, Barnett & Maxwell, P.C., No. 14-16632 (9th Cir. Aug. 25,

2014); see also id. (9th Cir. Mar. 13, 2015, ECF No. 25); id.

(9th Cir. Dec. 10, 2014, ECF No. 14).

dismiss without prejudice. Thereafter, Miller filed its Third

Amended Complaint. Morgan Stanley again answered the complaint,

and KPMG-HK filed the motion to dismiss both counts against it

for inadequate pleadings now before me.

The claims relevant to the instant motion – those brought

by Miller against KPMG-HK – are that the statements in the 2008

and 2009 audit reports, regarding KPMG-HK’s compliance with the

PCAOB standards and Shengda’s compliance with GAAP, constitute

negligent misrepresentation and violate § 18 of the Exchange

Act, and further that the statement in KPMG-HK’s comfort letter

that Shengda’s 2010 quarterly financial statements conformed

with GAAP also constitutes negligent misrepresentation. TAC

¶¶ 268, 272, 277, 278.

III. STANDARD OF REVIEW

In order to survive a motion to dismiss pursuant to Fed. R.

Civ. P. 12(b)(6), “a complaint must contain sufficient factual

matter, accepted as true, to state a claim to relief that is

plausible on its face.” Ashcroft v. Iqbal, 556 U.S. 662, 678

(2009) (internal quotation marks and citation omitted).

Dismissal for failure to state a claim is appropriate when the

pleadings set forth nothing more than “[t]hreadbare recitals of

the elements of a cause of action, supported by mere conclusory

statements.” Id.; see Maldonado v. Fontanes, 568 F.3d 263, 268

(1st Cir. 2009); see also Menard v. CSX Transp., Inc., 698 F.3d

40, 45 (1st Cir. 2012).

The controlling pleading is the Plaintiffs’ Third Amended

Complaint. Although I am “generally limited to considering

facts and documents that are part of or incorporated into the

complaint,” Giragosian v. Ryan, 547 F.3d 59, 65 (1st Cir. 2008)

(citation and internal quotation marks omitted), I may also

consider documents to which “a complaint’s factual allegations

are expressly linked.” Beddall v. State St. Bank & Trust Co.,

137 F.3d 12, 17 (1st Cir. 1998); see In re Citigroup, Inc., 535

F.3d 45, 52 (1st Cir. 2008). Here, I will consider the audit

reports prepared by KPMG-HK for fiscal years 2008 and 2009,

including the 2008 internal control audit report; the comfort

letter issued by KPMG-HK in December 2010; the 2011 press

releases, which have been provided by the Plaintiff; and

relevant SEC filings to the extent they have been incorporated

into the Third Amended Complaint and provided by the parties.13

13 KPMG-HK submits a wealth of additional evidentiary material in

an attempt to rebut factual assertions made in the Third Amended

Complaint. If I rely on evidentiary material beyond “the

complaint, documents annexed to it,” “other materials fairly

incorporated within it,” and “matters that are susceptible to

judicial notice,” the motion to dismiss must be converted into a

Rule 56 motion for summary judgment under Rule 12(d). Rodi v.

So. New Eng. Sch. of Law, 389 F.3d 5, 12 (1st Cir. 2004); see

Garita Hotel Ltd. P’ship v. Ponce Fed. Bank, F.S.B., 958 F.2d

15, 18-19 (1st Cir. 1992); see also Giragosian, 547 F.3d at 65.

It is premature to do so in this case, where no discovery has

been conducted. Accordingly, I limit my consideration of

IV. DISCUSSION

A. Section 18 Claim

1. Pleading Requirements

Federal Rule of Civil Procedure 8(a)(2) requires that a

complaint provide “a short and plain statement of the claim

showing that the pleader is entitled to relief.” Claims under

§ 18 of the Exchange Act are subject to the heightened “clarity

and basis” pleading requirement of the Private Securities

Litigation Reform Act of 1995 (“PSLRA”), 15 U.S.C. § 78u-4. See

generally In re Stone & Webster, Inc., Sec. Litig., 414 F.3d

187, 195, (1st. Cir. 2005) (“The clarity-and-basis requirement

of the PSLRA . . . seem to apply equally to claims under . . .

§ 18.”). Under this requirement, plaintiffs 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)(B); see In re Stone

& Webster, Inc., 414 F.3d at 194-95, 199. Where the allegations

are made on the basis of information and belief, plaintiffs must

specifically identify the sources used in investigating the

claims that form the basis for their allegations. See Special

additional materials to those fairly incorporated within the

Third Amended Complaint.

Situations Fund III, L.P. v. Am. Dental Partners, Inc., 775 F.

Supp. 2d 227, 238-39 (D. Mass. 2011).

Since the passage of the PSLRA, the First Circuit has

observed that the PSLRA pleading standards are “congruent and

consistent” with its own prior interpretation of Federal Rule of

Civil Procedure 9(b), and that both essentially impose the same

requirements. Greebel v. FTP Software, Inc., 194 F.3d 185, 193-

94 (1st Cir. 1999); see In re Stone & Webster, Inc., 414 F.3d at

195, 199. Consistent with Greebel, other judges in this

district have concluded that Rule 9(b) applies to § 18 claims.

See Lindner Dividend Fund, Inc. v. Ernst & Young, 880 F. Supp.

49, 57 (D. Mass. 1995) (collecting cases and finding Rule 9(b)

applicable to § 18 claims).14 Accordingly, I hold that Miller’s

§ 18 claim must satisfy the pleading standards of both the PSLRA

and Rule 9(b), which requires Miller to “state with

14 Miller suggests that the guidance of Greebel and the Rule 9(b)

heightened pleading standards do not apply here because the

relevant issue is falsity, not scienter. This approach is

consistent with Judge Mahan’s conclusion in Oaktree I, 963 F.

Supp. 2d at 1074-75, that Rule 8(a)(2), rather than Rule 9(b),

sets the pleading standards, accompanied by those imposed by the

PSLRA, because a § 18 claim does not require scienter and

therefore does not require fraud. I must, however, decline to

depart from this district’s consistent response to Greebel,

which is contrary to Judge Mahan’s approach.

Nevertheless, I do note that other pleading requirements

imposed by the PSLRA regarding the required state of mind (i.e.,

the “strong inference requirement”) do not apply here, because

§ 18 lacks a scienter requirement. See In re Stone & Webster,

Inc., 414 F.3d at 195-96; see also 15 U.S.C. § 78u-4(b)(2).

particularity the circumstances constituting fraud or mistake.”

See McGinty v. Beranger Volkswagen, Inc., 633 F.2d 226, 228 (1st

Cir. 1980) (Rule 9(b) requires “specification of the time,

place, and content of an alleged false representation”),

superseded in part by the PSLRA, Pub. L. No. 104-67, 109 Stat.

737 (1995).

To make a claim under § 18(a), Miller must plead that “(i)

the defendant made a [materially] false or misleading statement,

(ii) the statement was contained in a document ‘filed’ pursuant

to the Exchange Act or any rule or regulation thereunder, (iii)

reliance on the false statement, and (iv) resulting loss to

[Miller].” In re Stone & Webster, Inc., 414 F.3d at 193; see 15

U.S.C. § 78r; Special Situations Fund, 775 F. Supp. 2d at 245.

Proof of scienter is not required. In re Stone & Webster, Inc.,

414 F.3d at 193, 202.

Miller has identified three specific SEC filings in which

it contends that KPMG-HK made false statements: (a) the 2008

audit report accompanying Shengda’s 2008 Form 10-K, (b) the 2008

internal control audit report accompanying Shengda’s 2008 Form

10-K, and (c) the 2009 audit report accompanying Shengda’s 2009

Form 10-K.15 These filings were included in the PPM on which the

15 Any review KPMG-HK may have conducted of Shengda’s interim or

quarterly 2010 financial statements — and which was conducted on

a Form 10-Q — cannot serve as the basis for a § 18 claim, and

Miller does not appear to plead as much in its Third Amended

Plaintiffs relied in deciding to purchase the Shengda bonds in

2010. KPMG-HK asserts that Miller has failed to satisfy

elements (i) that any statements therein were false or

misleading, and (iv) that Miller’s loss was caused by KPMG-HK’s

false representations for each of these documents.16

2. False or Misleading Statements

What is required to plead and prove falsity under federal

securities laws depends on whether the statement at issue is one

of fact or opinion. The Supreme Court clarified the distinction

between these types of statements and when they may be

actionable for their falsity in Omnicare, Inc. v. Laborers

Complaint. See 17 C.F.R. § 240.13a-13(d) (specifically

excluding “the financial information required by Part I of Form

10-Q” from § 18 liability); INTERIM AUDITING STANDARDS, PUBLIC COMPANY

ACCOUNTING OVERSIGHT BOARD (hereinafter “AU”) § 722.07; see also

Special Situations Fund III QP, L.P. v. Deloitte Touche Tohmatsu

CPA, Ltd., 96 F. Supp. 3d 325, 346-47 (S.D.N.Y. 2015) (allegedly

false portions of financial statements in Form 10-Q filings are

not actionable under § 18), aff’d, 645 F. App’x 72 (2d Cir.

2016), cert. denied, 137 S. Ct. 186 (2016).

16 At the hearing on this motion, and in a footnote in its

supplemental briefing filed after that hearing, KPMG-HK asserted

that Miller has not alleged reliance on KPMG-HK’s 2008 internal

control audit report. I am satisfied that Miller has adequately

alleged, at least generally, that it relied on the documents

contained in the PPM, including the audit reports appearing in

the 2008 and 2009 Form 10-Ks, in purchasing the Shengda notes.

TAC ¶¶ 20-22, 26, 32, 279. See generally In re PolyMedica Corp.

Sec. Litig., 432 F.3d 1 (1st Cir. 2005) (discussing reliance

element).

District Council Construction Industry Pension Fund, 135 S. Ct.

1318 (2015).17

In Omnicare, the Supreme Court reasoned that:

A fact is “a thing done or existing” or “[a]n actual

happening” . . . [whereas] [a]n opinion is “a belief[,]

a view,” or a “sentiment which the mind forms of persons

or things.” . . . Most important, a statement of fact

(“the coffee is hot”) expresses certainty about a thing,

whereas a statement of opinion (“I think the coffee is

hot”) does not.

17 Omnicare involved a claim under § 11 of the Securities Act.

Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension

Fund, 135 S. Ct. 1318, 1323 (2015). Although § 18 employs a

meaningfully different legal standard from other federal

securities laws, the element of a false or misleading material

statement is consistent across the securities laws that require

it, including § 11 of the Securities Act and § 18 of the

Exchange Act. See In re Sanofi Sec. Litig., 87 F. Supp. 3d 510,

527 (S.D.N.Y. 2015) (“existence of a false or misleading

statement or omission of material fact” is common element for

claims under §§ 10(b), 18, and 20(a) of Exchange Act and §§ 11

and 12(a)(2) of the Securities Act); see also Fed. Hous. Fin.

Agency v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441, 555

n.170 (S.D.N.Y. 2015) (observing that “test for whether a

statement is materially misleading” is identical for claims

under various securities laws), aff’d, 873 F.3d 85 (2d Cir.

2017); Hill v. State St. Corp., Master Docket No. 09-cv-12146-

NG, 2011 WL 3420439, at *22-23 (D. Mass. Aug. 3, 2011) (citing

Plumbers’ Union Local No. 12 v. Nomura Asset Acceptance Corp.,

632 F.3d 762 (1st Cir. 2011), a case involving false opinions

under Securities Act, in analysis of Exchange Act claim).

Accordingly, case law discussing the requirements for a

materially false statement from across the securities landscape

is instructive. Cases arising under § 11 are particularly

instructive for § 18 claims because neither section requires

proof of scienter. See Ernst & Ernst v. Hochfelder, 425 U.S.

185, 211, n.31 (1976); cf. Herman & MacLean v. Huddleston, 459

U.S. 375, 382 (1983) (absence of scienter requirement for § 11

claim places “relatively minimal burden” on plaintiff compared

to § 10(b) claim); In re Stone & Webster, Inc., 414 F.3d at 193

(§ 18 is unlike § 10(b) because state of mind is a defense

rather than a necessary element).

Omnicare, 135 S. Ct. at 1325 (citations omitted; some

alterations in original). The Court observed that § 11

liability – like § 18 liability - is limited to untrue

statements of fact;18 it generally does not encompass “a sincere

statement of pure opinion . . . regardless whether an investor

can ultimately prove the belief wrong.” Id. at 1325-26, 1327

(emphasis added).

However, statements of opinion may be actionable when the

fact affirmed by the statement of opinion, namely “that the

speaker actually holds the stated belief,” is untrue. Id. at

1326. A statement of opinion accordingly may be the basis for

§ 11 liability if the stated belief is both inaccurate (i.e.,

not true) and not held by the speaker. See id. at 1326 & n.2

(adopting reasoning of Virginia Bankshares, Inc. v. Sandberg,

501 U.S. 1083, 1096 (1991), that “inadvertently correct

assessment” relieves speaker of liability). In addition, a

statement of opinion that contains any “embedded statements of

18 Section 11 of the Securities Act, codified as 15 U.S.C.

§ 77k(a), imposes liability if “any part of the registration

statement . . . contained an untrue statement of a material fact

or omitted to state a material fact required to be stated

therein or necessary to make the statements therein not

misleading.” Section 18 of the Exchange Act, codified as 15

U.S.C. § 78r(a), imposes liability for “any statement in any

application, report, or document filed pursuant to [securities

laws] or any undertaking contained in a registration statement

. . . which statement was at the time and in the light of the

circumstances under which it was made false or misleading with

respect to any material fact.”

fact” is actionable if the supporting fact itself is untrue,

because the statement “affirm[s] not only the speaker’s state of

mind . . . but also an underlying fact.” Id. at 1327.

The Omnicare Court also explained that under the separate

material omissions clause of § 11, a pure statement of opinion

may be actionable if the “statement omits material facts about

the issuer’s inquiry into or knowledge concerning a statement of

opinion, and if those facts conflict with what a reasonable

investor would take from the statement itself.” Id. at 1329.

Liability thus “may result from omission of facts – for example,

the fact that the speaker failed to conduct any investigation –

that rebut the recipient’s predictable inference.” Id. at

1330.19

Omnicare’s framework for claims arising under § 18 has been

deployed in the lower courts. See, e.g., Special Situations

Fund III QP, L.P. v. Deloitte Touche Tohmatsu CPA, Ltd., 96 F.

19 Although § 18 does not have a separate omissions clause,

numerous courts have recognized that material omissions can be

actionable under § 18 if the speaker failed “to include material

information in a necessary document,” resulting “in a false and

misleading statement.” In re Caesars Palace Sec. Litig., 360 F.

Supp. 366, 386 n.19 (S.D.N.Y. 1973); see Motient Corp. v.

Dondero, 529 F.3d 532, 536 (5th Cir. 2008); Magna Inv. Corp. v.

John Does 1-200, 931 F.2d 38, 39 (11th Cir. 1991) (per curiam);

Ross v. A.H. Robins Co., 607 F.2d 545, 556 (2d Cir. 1979); In re

Sanofi, 87 F. Supp. 3d at 527; Transit Rail, LLC v. Marsala, No.

05-CV-0564(C), 2007 WL 2089273, at *8 n.6 (W.D.N.Y. July 20,

2007); In re Alstom SA Sec. Litig., 406 F. Supp. 2d 433, 478

(S.D.N.Y. 2005); Lindner Dividend Fund, Inc. v. Ernst & Young,

880 F. Supp. 49, 55 (D. Mass. 1995).

Supp. 3d 325, 347 (S.D.N.Y. 2015) (citing Omnicare, 135 S. Ct.

at 1327), aff’d, 645 F. App’x 72 (2d Cir. 2016), cert. denied,

137 S. Ct. 186 (2016). The Supreme Court’s parsing of

statements in Omnicare is consistent with much of the prior case

law for claims of false statements under § 11 and § 18, albeit

permitting a slightly more expansive reach. See, e.g., In re

Merck & Co., Inc. Sec., Derivative & “ERISA” Litig., Civ. Action

Nos. 05-1151(SRC), 05-2367(SRC), MDL No. 1658(SRC), 2015 WL

2250472, at *21 (D.N.J. May. 13, 2015) (Omnicare is consistent

with prior Third Circuit and district court precedent); In re

BioScrip, Inc. Sec. Litig., 95 F. Supp. 3d 711, 726-29 (S.D.N.Y.

2015) (Omnicare is consistent with much of Second Circuit

precedent), reconsideration denied, 2015 WL 3540736 (S.D.N.Y.

June 5, 2015).

Existing precedent, read in light of Omnicare, illustrates

the following pleading requirements for a material misstatement

or omission under § 18. For a statement of fact, the plaintiff

need only plead that the statement itself is untrue or lacked a

reasonable basis (i.e., objective falsity). See Fait v. Regions

Fin. Corp., 655 F.3d 105, 110 (2d Cir. 2011). If the allegation

is the omission of a material fact, the plaintiff must plead

that “disclosure of [the omitted] information is ‘necessary to

make . . . [the] statements made, in the light of the

circumstances under which they were made, not misleading.’” In

re Sanofi Sec. Litig., 87 F. Supp. 3d 510, 527 (S.D.N.Y. 2015)

(quoting Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27,

44, 131 S. Ct. 1309 (2011) (internal quotation marks and

citation omitted)).

For a statement of opinion, the plaintiff must plead that

the statement falsely represented the speaker’s belief at the

time it was made (i.e., that the speaker did not sincerely

believe the statement) and that it was untrue; that a statement

of fact embedded within the opinion is untrue; or that the

speaker omitted material facts that would make the statement

misleading to a reasonable investor. See Omnicare, 135 S. Ct.

at 1325-27, 1329-30; Plumbers’ Union Local No. 12 Pension Fund

v. Nomura Asset Acceptance Corp., 632 F.3d 762, 775 (1st Cir.

2011); see also Corban v. Sarepta Therapeutics, Inc., No. 14-cv-

10201-IT, 2015 WL 1505693, at *6 (D. Mass. Mar. 31, 2015); In re

BioScrip, 95 F. Supp. 3d at 728-29; In re Sanofi, 87 F. Supp. 3d

at 527-28. An adequate pleading of falsity for an opinion

therefore requires subjective falsity only in the absence of

allegations that an embedded statement of fact was untrue at the

time or that there was a material omission in the opinion. See

Omnicare, 135 S. Ct. at 1326 & n.2; Plumbers’ Union, 632 F.3d at

775; In re Credit Suisse First Bos. Corp., 431 F.3d 36, 47 (1st

Cir. 2005), overruled on other grounds by Tellabs, Inc. v. Makor

Issues & Rights, Ltd., 551 U.S. 308 (2007); see also Fait, 655

F.3d at 110.

a. Conformance of KPMG-HK’s Audit of Shengda’s

Financial Statements and Internal Controls with

PCAOB Standards

Miller first challenges as false KPMG-HK’s statements, in

its 2008 and 2009 audit reports and in its 2008 internal control

audit report, that it “conducted [its] audit[s] in accordance

with the standards of the [PCAOB] (United States).” TAC ¶¶ 59-

61(a), (c), 108-208; 2008 Report; 2008 Internal Control Report;

2009 Report. The PCAOB, created by the Sarbanes Oxley Act of

2002, establishes and maintains standards that auditors must

follow in auditing U.S. public companies. See Free Enter. Fund

v. Pub. Co. Accounting Oversight Bd., 561 U.S. 477, 484-85

(2010). Among these standards are “generally accepted auditing

standards” (“GAAS”), codified as AU § 150 in the PCAOB

standards.

The parties dispute whether KPMG-HK’s statement of

compliance is one of fact or opinion. Many courts, following a

decision by Judge Kaplan in the Southern District of New York,

have concluded that statements regarding GAAS compliance in an

audit report are opinions.20 See In re Lehman Bros. Sec. & ERISA

20 The classification in In re Lehman Brothers of auditor

statements of GAAS compliance as opinions has been consistently

followed within the Southern District of New York. See, e.g.,

In re Puda Coal Sec. Inc., Litig., 30 F. Supp. 3d 230, 259

Litig., 799 F. Supp. 2d 258, 302 (S.D.N.Y. 2011) (“[Auditor’s]

statement regarding GAAS compliance inherently was one of

opinion.”); see also In re Colonial Bancgroup, Inc. Sec. Litig.,

9 F. Supp. 3d 1258, 1264-65 (M.D. Ala. 2014); Buttonwood Tree

Value Partners, LP v. Sweeney, No. SACV 10-00537-CJC, 2012 WL

2086607, at *2 (C.D. Cal. June 7, 2012). KPMG-HK urges

adherence to this interpretation.

Several other courts have implied that they would be open

to considering a statement of PCAOB/GAAS compliance to be a

statement of fact. See, e.g., Deephaven Private Placement

Trading, Ltd. v. Grant Thornton & Co., 454 F.3d 1168, 1175-76

(10th Cir. 2006); Edward J. Goodman Life Income Trust v. Jabil

Circuit, Inc., 595 F. Supp. 2d 1253, 1282 (M.D. Fla. 2009),

aff’d, 594 F.3d 783 (11th Cir. 2010); see also MHC Mut.

Conversion Fund, L.P. v. Sandler O’Neill & Partners, L.P., 761

F.3d 1109, 1117 n.6 (10th Cir. 2014) (clarifying that Deephaven

did not hold whether statement was one of fact or opinion).21

(S.D.N.Y. 2014), aff’d, Querub v. Hong Kong, 649 F. App’x 55 (2d

Cir. 2016); Hanson v. Frazer, LLP, Nos. 12 Civ. 3166(JSR), 12

Civ. 4222(JSR), 2013 WL 5372749, at *8 (S.D.N.Y. Sept. 24,

2013); Perry v. Duoyuan Printing, Inc., No. 10 Civ. 7235(GBD),

2013 WL 4505199, at *5 (S.D.N.Y. Aug. 22, 2013); In re Longtop

Fin. Techs. Ltd. Sec. Litig., 910 F. Supp. 2d 561, 580 (S.D.N.Y.

2012).

21 In the parallel litigation described in supra note 12, Judge

Mahan declined to resolve the classification of the statement of

GAAS compliance, because objective falsity was not adequately

alleged, and therefore the statement would not be actionable as

a statement of fact or opinion. See Oaktree I, 963 F. Supp. 2d

The parties’ research – and my own – has found only one case in

which a judge has actually concluded that a statement of an

audit’s compliance with the PCAOB standards or GAAS is a

statement of fact. See In re Wash. Mut., Inc. Sec., Derivative

& ERISA Litig., 694 F. Supp. 2d 1192, 1224 (W.D. Wash. 2009)

(“Whether or not [auditor] employed the PCAOB standards is a

verifiable factual statement that is material to those relying

on its certification of [plaintiff’s] internal controls”).

In the wake of Omnicare, I have come to agree with Judge

Pechman that statements by auditors of their own compliance with

the PCAOB standards or GAAS are statements of fact. See In re

Wash. Mut., 694 F. Supp. 2d at 1224. Because the auditor itself

is the one tasked with complying with the standards, the

statement that an auditor has so complied in conducting its

audit is best understood as one of fact. Compare In re Credit

Suisse, 431 F.3d at 47 (analysts’ stock ratings are “best

understood as statements of opinion, not as unadulterated

statements of objective fact,” because “they rest upon

at 1086; see also In re Stone & Webster, Inc., 414 F.3d at 209

(considering only objective falsity of statement of GAAS

compliance). This option of declining to classify is no longer

available in light of the broader permissible bases for

liability of an opinion statement following Omnicare. In a

later decision in the same case, Judge Mahan considered only the

objective falsity of a statement of GAAS compliance but

explicitly classified a statement of GAAP compliance as one of

opinion, and accordingly considered both objective and

subjective falsity. Oaktree II, 2014 WL 3816392, at *4-5.

outsiders’ views about a corporation rather than upon a

corporate insider’s factual assertions regarding his or her own

company”). There is no reason that an auditor cannot state with

certainty that it followed the PCAOB standards and the GAAS

therein as it understood them, including that it exercised the

independent judgment that is required by those standards. Cf.

Omnicare, 135 S. Ct. at 1325 (statement of fact is expression of

“certainty about a thing”).

The rationale for the classification of such statements as

opinions appears to stem from the nature of the GAAS themselves,

which Judge Kaplan in In re Lehman Brothers characterized as

“broadly stated” and “couched in rather general and in some

cases inherently subjective terms.” In re Lehman Bros., 799 F.

Supp. 2d at 300; see Buttonwood, 2012 WL 2086607, at *2. That

applying and following the GAAS requires the exercise of

discretion, see, e.g., AU § 230.11, does not make them any less

identifiable as guiding standards, however. The PCAOB codifies

its standards and sets forth the GAAS, which consist of ten

general standards and are themselves codified by the American

Institute of CPAs (“AICPA”) as AU § 150. See SEC v. Arthur

Young & Co., 590 F.2d 785, 788 n.2 (9th Cir. 1979); In re

WorldCom, Inc. Sec. Litig., 352 F. Supp. 2d 472, 479 (S.D.N.Y.

2005). Although one auditor may apply the standards differently

from another, there is sufficient uniformity that a fact-finder

may assess compliance using a reasonable person standard, asking

“whether a reasonable auditor would have taken such steps under

the circumstances.” In re Puda Coal Sec. Inc., Litig., 30 F.

Supp. 3d 230, 259 (S.D.N.Y. 2014), aff’d, Querub v. Hong Kong,

649 F. App’x 55 (2d Cir. 2016); see also Omnicare, 135 S. Ct. at

1332 (“Numerous legal rules hinge on what a reasonable person

would think or expect.”); cf. In re WorldCom, 352 F. Supp. 2d at

481.22

Because a statement of compliance with the PCAOB standards

is one of fact, Miller need only show, through well-pleaded

allegations satisfying the heightened standards of the PSLRA and

Rule 9(b), that KPMG-HK failed to perform its audits in

compliance with the PCAOB standards.

i. Failure to Investigate False Statements

About SSCM by Shengda’s CFO

Miller identifies numerous GAAS and other PCAOB

requirements that it alleges KPMG-HK knowingly failed to

satisfy. The largest collection of such allegations involves

22 KPMG-HK makes much of the fact that the 2008 and 2009 audit

reports in which this statement appears frequently refer to

KPMG-HK’s “opinion.” But the opinion contained in those reports

is regarding the consolidated financial statements of Shengda,

and the basis for those opinions, as the reports indicate, is

KPMG-HK’s audit of those financial statements. See 2008 Report;

2009 Report. There is no qualification of the statement of

PCAOB compliance with “we believe” or “in our opinion.”

Instead, “[i]n our opinion” precedes only the statement that

Shengda’s consolidated financial statements conform with GAAP.

2008 Report; 2009 Report.

KPMG-HK’s conduct following its discovery of a misrepresentation

by management regarding a related party.

In August 2007, Shengda’s Chief Financial Officer, Anhui

Guo, reported to Shengda’s previous auditor, Hansen, and to

Shengda’s board that Shengda had sold its interest in Shandong

Shengda Chemical Machinery Co. Ltd. (“SSCM”) in an arm’s length

transaction to Prosper Crown Limited, and that SSCM was no

longer a related party. TAC ¶¶ 40, 112-114. This was

inaccurate, because Shengda’s CEO, Xiangzhi Chen (“X. Chen”),

continued to serve as the CEO of SSCM, making it a related party

requiring disclosure. TAC ¶¶ 41, 112-113, 120. Hansen

expressed skepticism over Guo’s representation and investigated

further, but Guo falsely affirmed by email to Hansen on February

18, 2008, that there was no relationship between SSCM and any

parties related to Shengda. Id. ¶¶ 115-118. Guo made the same

representations to Shengda’s Audit Committee throughout the

year. Id. ¶¶ 120-124. As a result, the Audit Committee did not

review transactions with SSCM for approval under its related-

party transaction policy. Id. ¶ 125. King & Shine Partners,

Ltd., a law firm that conducted due diligence for Shengda, was

similarly unaware that SSCM remained a related party. Id.

¶ 133.

Miller alleges that when KPMG-HK became Shengda’s auditor,

it inquired about related parties and, like those inquiring

before it, did not receive an indication from management that

SSCM was a related party after July 2007. TAC ¶ 126. But on

February 14, 2009, Michael Tse, a KPMG-HK auditor, learned from

A. Carl Mudd, the chair of Shengda’s Audit Committee, that X.

Chen continued to be SSCM’s CEO. Id. ¶¶ 127, 130. In addition,

KPMG-HK knew that Prosper Crown had paid only $9.3 million for

SSCM, despite SSCM’s 2007 revenues of $45 million. Id. ¶ 137.

Both of these facts suggested that the sale to Prosper Crown was

not an arm’s length transaction, and that SSCM remained a

related party.

Miller alleges that what KPMG-HK did upon its discovery

that Guo had misrepresented SSCM’s status, and that SSCM

remained a related party, did not comply with the PCAOB

standards in several respects.

First, Miller alleges that KPMG-HK did not adequately

confirm the precise nature of the relationship between SSCM and

Shengda through extrinsic evidence. TAC ¶¶ 134, 150-152.

Because KPMG-HK knew that SSCM was a related party, it was

required under the PCAOB standards to obtain assurances from the

board that the related-party transaction was approved; to obtain

information about the related party and other significant

information from intermediaries, other agencies, and the prior

auditor; and to confirm the transactions between Shengda and

SSCM, among other responsibilities. AU §§ 315.09, 334.08-.10;

see AS No. 18. TAC ¶¶ 130, 150-151. Miller identifies two

specific sources that it contends KPMG-HK should have consulted

but did not: Prosper Crown’s public corporate records filed in

Hong Kong and available on the internet at a cost, and SSCM’s

AIC filings. Id. ¶¶ 134, 151(a), (d). These sources would have

revealed that a Shengda executive, Pu Li, was Prosper Crown’s

sole director, and its general manager was Zhen Chen (“Z.

Chen”), an individual whom Miller describes as “a protégé” of

Shengda’s CEO X. Chen. Id. ¶¶ 134, 151(a), (d). But these

allegations are not sufficient to establish that KPMG-HK failed

adequately to satisfy the directives of the PCAOB standards

Miller cites. TAC ¶¶ 130, 150-151.

Additional allegations assert that KPMG-HK corresponded

with Hansen, King & Shine, Mudd, Shengda management, and the

Shengda board generally about the transactions between SSCM and

Shengda. Id. ¶¶ 99-101, 128-134, 209. Miller’s allegation that

KPMG-HK would have learned something new from consulting the

foreign document filings is belied by its allegation that the

same names were disclosed in Guo’s email to Hansen on February

18, 2008, in which Guo expressly represented that these

individuals “have no relationship with ShengdaTech, Inc.” Id.

¶¶ 118, 151(a). Miller does not specifically allege that the

Hong Kong corporate records and AIC filings would have revealed

the connections these individuals had to Shengda. Nor does

Miller’s additional allegation that KPMG-HK should have

confirmed transactions with the banks that processed payments

from Shengda to SSCM indicate what more that investigation would

have provided to KPMG-HK on this issue. Id. ¶ 151(b). See

Oaktree Capital Mgmt., L.P. v. KPMG (Oaktree I), 963 F. Supp. 2d

1064, 1086-87 (D. Nev. 2013); Lindner Dividend Fund, 880 F.

Supp. at 58.

Second, Miller alleges that KPMG-HK’s discovery that SSCM

remained a related party required it to investigate whether

Guo’s prior representations were lies – and illegal acts – or

mere mistakes. TAC ¶¶ 131-146. Investigation following

suspicion of a possible illegal act is required under both

federal securities laws and the PCAOB standards to determine

whether a corrective disclosure is needed and whether the

auditor can continue to rely on management’s representations on

any matter, and generally in furtherance of an auditor’s

obligation to employ professional skepticism. See 15 U.S.C.

§ 78j-1(b)(1)(B); AU §§ 110.02, 316.13, .16; 317.10, .11, .16,

.19-.20; 333.02-.04; see also TAC ¶¶ 108-111, 141-144, 147-150.

Although determining whether an act is illegal is “normally

beyond the auditor’s professional competence,” AU § 317.03, the

auditor must make some attempt to determine the act’s

illegality. In detecting and reporting misstatements resulting

from illegal acts relevant to financial statements, auditors are

guided by both AU § 317 and AU § 110. The PCAOB standards

suggest that an auditor read minutes, inquire of management and

the client’s legal counsel, examine supporting documents, and

test the details of transactions and balances with third

parties. AU §§ 317.08, .10, .11. If an auditor is unable to

determine if an act is illegal, the auditor need only “consider

the effect on his report,” and may need to disclaim an opinion

on the financial statements. AU §§ 317.19, .21. If the auditor

has concluded that “an illegal act has a material effect on the

financial statements” and has not been disclosed, the auditor

should “express a qualified opinion or an adverse opinion on the

financial statements taken as a whole, depending on the

materiality of the effect on the financial statements,” AU

§ 317.18, and should inform the Audit Committee and senior

management. 15 U.S.C. § 78j-1(b)(1)(B). TAC ¶¶ 143-144.

Miller alleges that KPMG-HK’s investigation into whether

Guo’s prior representations were intentionally or inadvertently

false was inadequate under these standards. TAC ¶¶ 137, 145.

In a March 23, 2009 memorandum summarizing its investigative

efforts, KPMG-HK indicated that it had corresponded with Hansen

and King & Shine regarding their knowledge and asked Shengda’s

management to represent that SSCM was not a related party;

however, KPMG-HK did not indicate that it asked specifically

whether Guo had lied to any of them.23 Id. ¶¶ 128-135, 145.

KPMG-HK argues that it is unreasonable to infer that this

memorandum encompassed the full scope of its investigation into

Guo; rather, it continued to gather information consistent with

its obligation under AU § 317, as demonstrated by Miller’s

allegation that KPMG-HK communicated about the related-party

disclosures with Guo by email several days after the

memorandum.24 Id. ¶ 100.

In addition, although Miller alleges that KPMG-HK did not

consult third-party records to confirm transactions, Miller does

allege that KPMG-HK consulted many of the sources suggested by

the PCAOB standards, including legal counsel and the prior

auditor. See AU §§ 317.08-.11. These source lists are merely

suggestions; an exhaustive exploration of them is not required

by the standards. See, e.g., AU § 317.11 (“The additional audit

procedures considered necessary, if any, might include

procedures such as the following . . . .”). Instead, auditors

23 To the extent Miller alleges that KPMG-HK did not satisfy its

obligation to inquire of its predecessor, Hansen, as required by

AU §§ 315.02 and .09, the allegations show that KPMG-HK did

correspond with Hansen on this issue and obtained what

information Hansen had regarding Guo’s representations at the

time. TAC ¶¶ 115-123, 128, 135, 145, 152.

24 KPMG-HK also points to additional facts beyond the Third

Amended Complaint. At this stage — particularly after multiple

repleadings — I see no reason to indulge the Plaintiffs’

invitation to look beyond the well-pleaded allegations,

construed in Miller’s favor, to determine whether Miller has

sufficiently stated a claim upon which relief may be granted.

are required to apply “those auditing procedures necessary to

afford a reasonable basis for an opinion regarding the financial

statements under audit[,]” and are to consider “representations

from management” as only “part of the evidential matter” they

obtain. AU § 333.02. Miller’s allegations do not support the

conclusion that KPMG-HK’s audit was so inadequate in its

assessment of related-party transactions and the representations

of management that it failed to meet these open-textured

standards. Compare McCurdy v. SEC, 396 F.3d 1258, 1260-61 (D.C.

Cir. 2005) (audit of receivable did not comport with GAAS

because auditor did not speak with any board member or with CEO

and did not examine or test the financial data CEO presented to

the board, even though auditor reviewed meeting minutes, spoke

to attorney, and reviewed company’s prior decision).

Miller further alleges that, following its investigation,

KPMG-HK neither brought the possibility that Guo had lied to the

attention of the Audit Committee, as evidenced by board meeting

minutes and the attestation of two Shengda board members, nor

disclaimed an opinion on Shengda’s 2008 financial statements.

TAC ¶¶ 135, 145. Both of these allegations are belied by other

allegations in the Third Amended Complaint. Mudd, the chair of

the Audit Committee, had a conversation with KPMG-HK

demonstrating that he knew he had incorrectly understood SSCM no

longer to be a related party because of earlier

misrepresentations by Guo. TAC ¶ 130. The PCAOB standards and

federal securities laws require only that the auditor “assure

himself that the audit committee is adequately informed as soon

as practicable and prior to the issuance of the auditor’s

report.” AU § 317.17; see 15 U.S.C. § 78j-1(b)(1)(B). Surely

the Audit Committee, with this knowledge, could infer that Guo’s

representations regarding SSCM were inaccurate and could respond

accordingly. KPMG-HK also communicated directly with Guo after

its discovery of the error, informing Guo that Shengda’s

“failure to disclose related-party transactions meant that its

financial statements contained material errors” and discussing

how to proceed appropriately with 2008 reporting. TAC ¶ 100.

Both of these interactions occurred prior to the issuance of

KPMG-HK’s 2009 audit report.

For the same reasons, Miller’s allegations regarding KPMG-

HK’s obligation to convince Shengda to restate its 2007

financials fail.25 TAC ¶¶ 100-101. SSCM was disclosed as a

related party in Shengda’s 2008 Form 10-K, after KPMG-HK

informed Shengda of this necessity, and KPMG-HK’s internal

control audit report filed along with the 10-K further

identified internal control weaknesses. Id. ¶¶ 59, 100, 209;

25 Shengda’s 2007 financials failed to disclose SSCM as a related

party. SFAS No. 154, a GAAP standard, requires disclosure of

errors discovered in previously issued financial statements.

TAC ¶¶ 100-101.

2008 Form 10-K at F-19. Miller has not identified any PCAOB

standard requiring further action on KPMG-HK’s part with regard

to corrective disclosure of SSCM’s related-party status for its

2008 financial statements.26 Similarly, KPMG-HK’s ultimate

discovery and appropriate representation of the related-party

status, despite Guo’s contrary representations, is consistent

with the PCAOB standards requiring auditors not to trust the

representations of management blindly.27 TAC ¶ 111; AU

§§ 333.02-.04.

In sum, although Miller has made “specific allegations

about the steps an auditor took, the way in which it planned its

audit, and the procedures it employed,” Oaktree I, 963 F. Supp.

2d at 1086, it has not demonstrated that these steps and

procedures were non-compliant with the PCAOB standards requiring

investigation of a potential illegal act, disclosure of a prior

26 Even if KPMG-HK had a duty to convince Shengda to issue a

corrective disclosure regarding its 2007 financial statements

and SSCM’s related-party status (despite not serving as

Shengda’s auditor for 2007), Miller could not adequately allege

loss causation, because SSCM’s status as a related party in

fiscal year 2007 was fully disclosed in 2009, prior to Miller’s

purchase of the Shengda bonds. TAC ¶¶ 100, 209.

27 To the extent Miller contends that KPMG-HK did not comply with

the PCAOB standards because it continued to rely on

representations from Guo after discovering that Guo had

incorrectly represented SSCM’s status, Miller offers no

allegations of KPMG-HK’s continued reliance. See AU § 220.02-

.04 (auditor must be independent), § 333.01 et seq. (guidance

for reliance on management representations).

material misstatement, skepticism of representations by

management, and disclosure of related-party transactions.

ii. Internal Control Deficiencies

Miller next alleges that KPMG-HK’s acknowledgment of

material weaknesses in Shengda’s internal controls in its 2008

internal control audit report did not satisfy the PCAOB

standards. Under AS No. 5.91, “[w]hen expressing an adverse

opinion on internal control over financial reporting because of

a material weakness, the auditor’s report must include . . .

[t]he definition of a material weakness . . . [,] [a] statement

that a material weakness has been identified and an

identification of the material weakness described in

management’s assessment.” TAC ¶ 210.

In its 2008 report, KPMG-HK stated that “[m]aterial

weaknesses have been identified and included in management’s

assessment related to the lack of adequate policies, procedures

and personnel to address the accounting for and disclosures of

non-routine transactions and the Company’s internal control over

the accounting for income taxes.”28 TAC ¶¶ 59, 61(c), 209-212;

2008 Internal Control Report. The report goes on to say that

“[i]n our opinion, because of the effect of the aforementioned

28 Although Miller challenges this statement as it appears in a

final report from Tse to Shengda’s Audit Committee, it is

actionable only as it appears in the audit report accompanying

Shengda’s 2008 Form 10-K. TAC ¶¶ 59, 209.

material weaknesses on the achievement of the objectives of the

control criteria, ShengdaTech, Inc. and subsidiaries have not

maintained effective internal control over financial reporting

as of December 31, 2008.” 2008 Internal Control Report.

Miller alleges that KPMG-HK did not specifically identify

as a material weakness “critical failure[s]” regarding

disclosure of related-party transactions with SSCM, and instead

disclosed “much more innocuous failures.” TAC ¶¶ 61(c), 211-

212. KPMG-HK, for its part, contends that “accounting for and

disclosures of non-routine transactions” encompasses related-

party transactions; Miller responds that Shengda’s transactions

with SSCM were in fact routine.

Drawing all reasonable inferences from the allegations in

Miller’s favor, I find Miller has adequately pled that KPMG-HK’s

internal control audit report omitted a material weakness that

was known to it at the time, and that required specific

disclosure under AS No. 5.91.29 See Stratte-McClure v. Morgan

Stanley, 776 F.3d 94, 101 (2d Cir. 2015) (“[A]n omission is

actionable under the securities laws only when the corporation

29 Although there is some case law suggesting that the duty to

report internal control weaknesses requires reporting to

management only, and not in the audit report itself, see Allied

Inv. Corp. v. KPMG Peat Marwick, 872 F. Supp. 1076, 1084 (D. Me.

1995) (citing Monroe v. Hughes, 31 F. 3d 772, 775 (9th Cir.

1994)), I am of the view that AS No. 5.90 and .91 now require an

adverse opinion from the auditor.

is subject to a duty to disclose the omitted facts.” (citation

omitted)). The disclosure of weaknesses concerning non-routine

transactions does not discharge the obligation to disclose a

weakness concerning related party transactions. AS No. 5.14

specifically identifies certain categories of controls that an

auditor can identify, including controls over “significant

unusual transactions” (i.e., non-routine transactions) and

controls over related party transactions. By listing these

separately, the PCAOB standards suggest that they are not

synonymous, and that disclosure of weaknesses in one area does

not constitute disclosure of weaknesses in another.

The Third Amended Complaint identifies particular facts

that tie a discrete auditing requirement to information known to

KPMG-HK at the time. Compare In re BioScrip, 95 F. Supp. 3d at

726-27 (statements suggesting that defendant “routinely

responded to investigatory requests from the Government, but was

not presently in the process of responding to such a request,”

was misleading, “because the inference is available that a

reasonable investor could have read them to mean that

[defendant] was not already in receipt of just such a request

for information”). Edward J. Goodman, 595 F. Supp. 2d at 1282.

A reasonable investor would expect that inadequate related-party

transaction disclosures would be identified as a material

weakness in this context, and therefore the absence of this

identification is actionable as a material omission. See

Omnicare, 135 S. Ct. at 1330, 1332.

iii. Failure to Establish Direct Contact in the

Confirmation Process

Miller next alleges that KPMG-HK performed an inadequate

confirmation process. Under the PCAOB standards, auditors may

employ a confirmation process “to obtain evidence from third

parties about financial statement assertions made by management”

as one procedure in the audit risk assessment. AU § 330.06; see

AU §§ 330.04-.09; see also AU § 150.02 (Standards of Field Work

No. 3) (“Sufficient appropriate evidential matter is to be

obtained through inspection, observation, inquiries, and

confirmations to afford a reasonable basis for an opinion

regarding the financial statements under audit.”). When there

is a greater “combined assessed level of inherent and control

risk,” the auditor generally needs greater assurances, which can

be obtained through confirmation procedures. AU § 330.07.

Contrary to Miller’s assertion, the PCAOB standards do not

require auditors to obtain independent confirmation of specific

financial statement entries; rather, whether and to what extent

to engage in a confirmation process is left to the discretion of

the auditor based on its assessment of inherent and control

risk. See AU §§ 330.05-.10. TAC ¶¶ 14(a), 153-154.

When an auditor chooses to perform a confirmation process,

“the auditor should maintain control over the confirmation

requests and responses” to minimize the chance of biased results

due to interception or alteration. AU § 330.28. This entails

“establishing direct communication between the intended

recipient and the auditor.” AU § 330.28. Further follow up,

such as a phone call, to ensure the validity of a confirmation

response is recommended by the PCAOB standards only when the

response comes in a form other than a written communication

mailed to the auditor. AU § 330.29.

Miller alleges that KPMG-HK did not comply with the PCAOB

standards when it engaged in its confirmation process because it

obtained the addresses for the confirmation addressees from

Shengda and did not check them against publicly available

information. TAC ¶¶ 156-158. Had KPMG-HK checked the

addresses, it would have discovered that Shengda had provided

the addresses of “insiders” who falsely confirmed every claim.

Id. ¶¶ 157-158. In addition, KPMG-HK did not conduct any site

visits to Shengda’s suppliers, customers, or banks. Id.

¶ 158(d). When KPMG-HK did ultimately call the confirmation

addressees at publicly available phone numbers, it learned that

“nearly all” of Shengda’s claims regarding its bank accounts,

accounts payable, and accounts receivable were inaccurate. Id.

¶ 161. Miller alleges that, in light of KPMG-HK’s prior

discovery “that management had already lied to Hansen, to its

board of directors, and to KPMG itself, about a material matter”

– presumably SSCM’s related-party status – KPMG-HK’s obligation

to employ professional skepticism should have made it

distrustful of the information provided by Shengda and led it to

engage in these additional confirmatory steps. Id. ¶¶ 149, 155;

see AU § 330.15.

This is a classic “should have, had they, must have”

allegation. See Oaktree I, 963 F. Supp. 2d at 1086-87. Nothing

in the PCAOB standards explicitly requires verifying

confirmation addresses against public records or making on-site

visits. As Judge Mahan observed, “[a]n auditor is not tasked

with checking over every single document and making contact with

every company that its client does business with . . . .”

Oaktree Capital Mgmt., L.P. v. KPMG (Oaktree II), No. 2:12-CV-

956 JCM (GWF), 2014 WL 3816392, at *4 (D. Nev. Aug. 4, 2014),

see supra note 12 for subsequent history of Oaktree II. Miller

has not alleged that any of the confirmations were received by

facsimile or orally, thereby triggering a need for confirmation

of their validity; to the contrary, Miller alleges that the

Shengda insiders mailed the completed confirmation forms back to

KPMG-HK as instructed. TAC ¶¶ 154, 157; see AU § 330.29

In Oaktree I, Judge Mahan concluded that “[a] number of

other explanations, including a failure by Shengda’s internal

accountants to detect management fraud, [or] a remarkably well-

covered management fraud scheme, . . . are equally or more

likely to have resulted in the inaccurate financial reporting

alleged by plaintiffs.” Oaktree I, 963 F. Supp. 2d at 1087.

Miller’s vague reference to an earlier “lie” by Shengda is not

sufficiently specific to give rise to the conclusion that KPMG-

HK should have distrusted all information coming from Shengda,

or that it should have suspected that addresses supplied by

Shengda for its banks, suppliers, and customers would be

inaccurate. The only identifiable culprit in the

misrepresentation of SSCM’s related-party status is Guo, and

Miller does not allege that it was Guo who provided the

addresses to KPMG-HK. Indeed, Miller does not identify who at

Shengda supplied the addresses. TAC ¶¶ 156-157.

In addition, although the auditing standards call for “a

heightened degree of professional skepticism” in certain

circumstances, such as when confirming “significant, unusual

year-end transactions that have a material effect on the

financial statements,” AU § 330.27, Miller does not identify the

timing of the confirmation process in relation to the SSCM

discussions or any other allegedly fraudulent conduct at Shengda

– including allegedly “vastly overstated” transactions – that

could have formed a basis for such heightened skepticism.30 As a

result, Miller does not allege that KPMG-HK determined that it

needed to conduct additional verification procedures in its

confirmation process.31 TAC ¶¶ 155-161. “[B]are allegations

that fraud discovered years later speaks for itself” are

insufficient. Oaktree I, 963 F. Supp. 2d at 1086. These

allegations are inadequate to render KPMG-HK’s statement of

compliance with the PCAOB standards false or misleading.32

30 In fact, Miller alleges that in March 2011 – after other red

flags came to KPMG-HK’s attention – KPMG-HK engaged in the

additional confirmation procedures suggested by the PCAOB

standards. TAC ¶¶ 161, 225, 227(b); see AU § 330.

31 Miller’s discussion of the June 2011 SEC interview of KPMG-HK

is irrelevant. TAC ¶¶ 159-160. In that interview, KPMG-HK

indicated that, as a general practice, it checks public sources

to verify addresses when the circumstances require it. Id.

There is no allegation that KPMG-HK believed that such

verification was necessary in this case. Id.

32 Miller’s additional allegation that KPMG-HK should have

investigated for potential fraud when it determined that the

confirmation rate was “unusually high” is not supported by the

PCAOB standards as they existed at the time. TAC ¶¶ 15(a), 162-

166. Miller relies on AS No. 14, Appendix C1.b.(14). TAC

¶ 164. Such a standard was not adopted until August 2010 and

applies only to audits of fiscal periods beginning on or after

December 15, 2010, five months after KPMG-HK submitted its 2009

audit report indicating that it had complied with the PCAOB

standards. See PCAOB Release No. 2010-004 (Aug. 5, 2010).

Moreover, Miller alleges that KPMG-HK revealed its belief that

the 2009 confirmation rate was unusually high to Shengda in May

2010 – well after its March 2010 audit report - and does not

specifically allege that KPMG-HK held this view at the time that

it prepared its audit report. TAC ¶¶ 165-166; see 15 U.S.C.

§ 78r(a) (statement must have been false or misleading “at the

time” it was made).

iv. Ignoring Red Flags

Miller next identifies discrepancies in the documentation

supporting Shengda’s financial statements that it alleges KPMG-

HK should have observed while conducting its 2008 and 2009

audits. TAC ¶¶ 167-208. It contends that KPMG-HK’s failure to

notice or act on these “red flags” violated the PCAOB standards

directing auditors to exercise due care and employ professional

skepticism, to assess the nature of the audited business

adequately, to obtain “[s]ufficient competent evidential matter

. . . to afford a reasonable basis for an opinion,” and to

respond to signals of potential fraud. AU §§ 110, 150.02,

230.07, 316.86; see TAC ¶¶ 19, 167.

Miller alleges that KPMG-HK did not recognize deficiencies

in the “chops” or seals that appeared on the confirmations sent

back to KPMG-HK in 2008 and 2009 by two banks where Shengda

allegedly held accounts. TAC ¶¶ 168-171. Miller alleges that

“a facially deficient chop is as much a red flag in China as a

signature claiming to be from a company’s CEO but bearing the

wrong name is in the U.S.” However, Miller makes no allegations

that KPMG-HK was required to check the chops against one another

in subsequent years in order to perform a PCAOB-compliant audit,

or that KPMG-HK would have possessed the requisite knowledge to

understand why the chops of the identified banks were deficient

at the time. Id. ¶¶ 15(b), 167-171. Furthermore, the PCAOB

standards recognize that “[a]n audit conducted in accordance

with GAAS rarely involves the authentication of such

documentation, nor are auditors trained as or expected to be

experts in such authentication.” AU § 316.09.33

Miller alleges that during the audit of Shengda’s 2010

financial statements, when KPMG-HK employed additional

confirmation procedures, KPMG-HK discovered that Shengda was

meddling with the confirmation process on behalf of its

subsidiaries.34 TAC ¶¶ 172-182. Once again, a mere allegation

33 In addition, Miller does not specifically allege that KPMG-HK

did not attempt to confirm the validity of the chops at the

time; it alleges only that when KPMG-HK contacted the banks by

phone in 2010 in auditing Shengda’s 2010 financial statements,

it discovered that Shengda did not hold accounts at those banks

of the size Shengda had represented. TAC ¶¶ 169-171. Miller

merely implies that KPMG-HK did not inspect the chops, because

“had it done so” in its 2008 and 2009 audits, “it would have

detected the fraud.” Id. ¶¶ 18, 227(f). All that Miller has

presented is an unsupported inference and a claim that KPMG-HK

failed to figure out that it was being duped. See In re Puda

Coal, 30 F. Supp. 3d at 260. Such allegations are not

actionable. Menard v. CSX Transp., Inc., 698 F.3d 40, 44 (1st

Cir. 2012) (“‘Information and belief’ does not mean pure

speculation.”).

34 These allegations pertain to two discoveries during the 2010

audit: switched confirmation envelopes and forged Value Added

Tax (“VAT”) receipts. TAC ¶¶ 172-182.

In conducting its audit, KPMG-HK created two separate audit

teams, one responsible for auditing Shengda’s operations in the

Shandong province, and one responsible for auditing Shengda’s

operations in the Shaanxi province. TAC ¶ 172. The audit teams

sent envelopes to the confirmation addressees that included

response envelopes directed to the specific team. Id. ¶¶ 173-

174. Miller alleges that “ShengdaTech caused purported Shandong

addressees to respond to KPMG in envelopes addressed to KPMG’s

Shanxi team, and vice versa,” which clearly signaled fraudulent

conduct. Id. ¶¶ 175-176.

that fraud was discovered, by conducting the procedure at a

later date, is not enough to demonstrate that KPMG-HK did not

adequately conduct its audit. Specific allegations (and an

identified basis for them) demonstrating that such a procedure

was required for the 2008 and 2009 audits or that, had it been

employed, it necessarily would have revealed fraud at the time,

are required. Cf. Oaktree I, 963 F. Supp. 2d at 1086-87

(“misstated financial statements from 2010 do not necessarily

reflect anything about financial statements made in 2008 and

2009”).

To the extent Miller identifies other red flags that should

have put KPMG-HK on notice of Shengda’s fraud — including

Shengda’s repeated accounting restatements, KPMG-HK’s alleged

urging of Shengda not to put certain things in writing, and the

receipt of a warning of potential fraud from a third party35 —

Also during its audit of the 2010 financials, KPMG-HK

selected six fapiao – certificates of payment or receipt – to

test and verify through a VAT invoice verification system

operated by one of the provinces in which Shengda did business.

Id. ¶¶ 177-182. In so doing, KPMG-HK discovered that all of

them were forged. Id. ¶ 182, 227(c).

Miller also suggests that KPMG-HK should have consulted

Shengda’s AIC filings to verify another red flag, an alleged tip

from someone concerning the implausible demand for Shengda’s

products. These allegations are barely pleaded and fail for the

same reasons. TAC ¶¶ 15(c), 62-65, 191; see In re Puda Coal, 30

F. Supp. 3d at 259; Perry, 2013 WL 4505199, at *5.

35 Miller alleges that during its fiscal year 2009 audit, KPMG-HK

became aware that “[a] person with some familiarity with the

market for ShengdaTech’s product [had said that] he thought the

these allegations are not tied to any applicable PCAOB standards

and speak only to KPMG-HK’s subjective knowledge. TAC ¶¶ 188-

191. Proof of subjective knowledge is not required here, and

its introduction as part of the analysis does not add to the

determination whether the pleadings demonstrate that KPMG-HK

failed to comply with the PCAOB standards in conducting its

audits.36 Id. ¶¶ 183-191.

The vast majority of Miller’s allegations of red flags fail

for the simple reason that “an unseen red flag cannot be

heeded.” Stephenson v. PricewaterhouseCoopers, LLP, 768 F.

Supp. 2d 562, 573 (S.D.N.Y. 2011). The PCAOB standards

company’s overall sales figures exceeded what he understood to

be the likely global market demand.” TAC ¶ 190.

The PCAOB standard Miller alleges that KPMG-HK violated in

not further pursuing this tip is the same it identifies in

relation to KPMG-HK’s failure to investigate the unusually high

confirmation rate. TAC ¶¶ 15(a), 162-166, 190. That auditing

standard was not introduced to the PCAOB standards until after

KPMG-HK filed its last actionable document in March 2010. See

supra note 34.

Even assuming that the PCAOB standards required follow-up

investigation, Miller has not satisfied the clarity and basis

requirement for this allegation. Miller implies but does not

specifically allege that KPMG-HK did not investigate this

warning. Miller’s allegations regarding KPMG-HK’s general

auditing practices do not establish whether KPMG-HK followed

them in its Shengda audits. TAC ¶¶ 18, 159, 190. Miller also

does not identify the source of the tip, how KPMG-HK received

it, or whether the statement in the tip was true. Id. ¶ 190.

36 Miller’s emphasis on New Mexico State Investment Council v.

Ernst & Young LLP, 641 F.3d 1089, 1097-98 (9th Cir. 2011), is

misplaced for this reason. That case discusses the relationship

between the number of red flags and how “cogent and compelling”

the inference of scienter is in evaluating a claim under § 10(b)

of the Exchange Act and Rule 10b-5 thereunder. Id. at 1098.

explicitly contemplate that “a properly planned and performed

audit may not detect a material misstatement resulting from

fraud,” and offer auditors direction in the reasonable steps

they can take to attempt to detect such issues. AU § 316.12.

Miller’s allegations fail to demonstrate with specificity how

KPMG-HK’s missing these red flags at the time and under the

circumstances violated the PCAOB standards. Cf. In re Stone &

Webster, Inc., 414 F.3d at 214 (finding clarity-and-basis

pleading standard not satisfied where complaint “lacks

concreteness as to how the conduct of the audit related to the

missed warning signs.”); In re Cabletron Sys., 311 F.3d at 36.

v. Alleged Violations After March 2010

Miller alleges that KPMG-HK made numerous discoveries

between May and November 2010 that revealed that several of

Shengda’s purported customers were false or non-existent and

that Shengda had been supplying KPMG-HK with forged checks and

bills of customer transactions. TAC ¶¶ 192-208. Miller also

alleges that KPMG-HK discovered additional information about

SSCM’s related-party status during this time, and that it failed

to act in accordance with the PCAOB standards in responding to

this information. Id.

The PCAOB standards set forth procedures for an auditor to

employ when it obtains material information it did not

previously possess. AU § 561.04. If the auditor determines

through further investigation that the information is reliable,

that “the facts existed at the date of his report,” and that the

information is such that “action should be taken to prevent

further reliance on his report,” the PCAOB standards instruct

auditors to advise their clients to make an appropriate

disclosure, and if the client refuses, to do so itself. AU

§ 561.04-.08; see In re Cabletron Sys., Inc., 311 F.3d 11, 36

(1st Cir. 2002) (recognizing duty to correct). Such disclosure

may include issuing revised financial statements and auditor’s

reports. AU § 561.06(a).

Although these standards, in light of KPMG-HK’s

discoveries in late 2010, may have required such action, they

cannot serve to render KPMG-HK’s earlier statements in March

2009 and March 2010 of compliance with the PCAOB standards false

or misleading for purposes of § 18, which requires that the

statement was false or misleading “at the time and in the light

of the circumstances under which it was made.” 15 U.S.C.

§ 78r(a); cf. In re Cabletron Sys., 311 F.3d at 36 (complaint

must demonstrate that eventual problems were known to defendants

at time statements were made).37

37 To the extent Miller identifies KPMG-HK’s December 2010

comfort letter – in which KPMG-HK acknowledged that Shengda’s

bond purchasers would rely on KPMG-HK’s audit report - as a

missed opportunity to correct issues in the prior disclosures, I

note only that the letter is not actionable under § 18.

vi. Import of the Magnitude of the Fraud and

the Ease of its Discovery

Finally, Miller alleges that the ease with which KPMG-HK

eventually uncovered such a large fraud shows a failure to

comply with PCAOB standards. Miller contends that KPMG-HK’s own

behaviors illustrate how central these above-described

investigative actions are to discovering fraud and why they

should have been undertaken during the annual audits. KPMG-HK

performed many of these investigative actions in March 2011 – at

which point it learned of the significant issues in Shengda’s

financial statements – and used these sources as evidence of

Shengda’s fraudulent activity.

In some cases, particularly where scienter is at issue, the

size of the fraud can “strongly suggest[]” that an audit did not

comply with the PCAOB standards. See McIntire v. China

MediaExpress Holdings, Inc., 927 F. Supp. 2d 105, 134 (S.D.N.Y.

2013); cf. In re MicroStrategy, Inc. Sec. Litig., 115 F. Supp.

2d 620, 652 (E.D. Va. 2000) (auditor’s ability to identify and

correct violations for two years of contracts in two weeks

supported inference of scienter stemming from magnitude of

restatement and simplicity of GAAP principles violated). But

see In re Longtop Fin. Techs. Ltd. Sec. Litig., 910 F. Supp. 2d

561, 578 (S.D.N.Y. 2012) (in context of proving scienter,

“fraud’s large size, standing alone, is insufficient to show

recklessness,” as is “rapidity with which [the] fraud

unraveled”).

Here, these considerations are not sufficiently compelling

to stand in as a proxy for the particularized allegations needed

to state a claim. To be sure, “[a]t the pleading stage, courts

have recognized that allegations of GAAS violations, coupled

with allegations that significant ‘red flags’ were ignored, can

suffice to withstand a motion to dismiss.” In re Suprema

Specialties, Inc. Sec. Litig., 438 F.3d 256, 279 (3d Cir. 2006);

see Greebel, 194 F.3d at 203-04. But as described above, the

red flags identified in the Third Amended Complaint are neither

actionable nor significant.

Miller’s claim that KPMG-HK did not perform its audits in

accordance with the PCAOB standards and GAAS rests primarily on

“a litany of conclusory allegations of failure to conform to

various GAAS standards,” In re Stone & Webster, Inc., 414 F.3d

at 214, suggesting only that KPMG-HK was duped throughout its

performance of facially PCAOB-compliant audits. That KPMG-HK

could have performed a more robust audit does not render the

audit it did perform non-compliant. See In re Puda Coal, 30 F.

Supp. 3d at 259-60. In light of the information KPMG-HK had at

the time and the relevant pleading standards, Miller’s

allegations can establish only that KPMG-HK’s statement of

compliance with the PCAOB standards in conducting its 2008

internal control audit was materially false or misleading

because it did not disclose a known material weakness.

b. Conformance of Shengda’s Financial Statements

with GAAP

Miller also challenges as false the following statement

that appeared in KPMG-HK’s 2008 and 2009 audit reports:

In our opinion, the consolidated financial statements

referred to above present fairly, in all material

respects, the financial position of ShengdaTech, Inc.

and subsidiaries as of [December 31, 2008, and December

31, 2009 and 2008, respectively], and the results of

their operations and their cash flows for the years then

ended, in conformity with U.S. generally accepted

accounting principles.

TAC ¶¶ 59-61(b), ¶¶ 62-107; 2008 Report; 2009 Report.

Miller concedes that the statement of compliance with GAAP

is a statement of opinion. For reasons that bear brief

explanation, I agree.

The GAAP themselves are broad, inherently subjective

standards, as Judge Kaplan and the other judges following his

opinion in In re Lehman Brothers characterize them; unlike the

PCAOB standards and the GAAS therein, however, the GAAP are not

rigorous codifications. See Buttonwood, 2012 WL 2086607, at *2;

In re WorldCom, 352 F. Supp. 2d at 478. GAAP “embody the

prevailing principles, conventions, and procedures defined by

the accounting industry from time to time.” Young v. Lepone,

305 F.3d 1, 5 n.1 (1st Cir. 2002); see Shalala v. Guernsey Mem’l

Hosp., 514 U.S. 87, 101 (1995). The Supreme Court has observed

that GAAP “are far from being a canonical set of rules,” Thor

Power Tool Co. v. Comm’r of Internal Revenue, 439 U.S. 522, 544

(1979), and are not compiled in “a single-source accounting

rulebook.” Shalala, 514 U.S. at 101. Instead, there are “19

different GAAP sources,” and an accountant must “consult an

elaborate hierarchy of GAAP sources to determine which treatment

to follow.” Shalala, 514 U.S. at 101. Because the GAAP are

meant to embody contemporary conventions and procedures, “GAAP

changes and, even at any one point, is often indeterminate.”

Id. This is in contrast to the PCAOB standards that, although

requiring the exercise of discretion, can be identified from one

source, and for which a statement of compliance is less a

statement of belief than an assertion carrying some certainty.

See In re WorldCom, 352 F. Supp. 2d at 479.

More significantly, this statement does not affirm the

auditor’s own conduct, but rather expresses the auditor’s

opinion on the conduct of a third-party: the entity whose

financial statements are being audited.38 See Deephaven, 454

F.3d at 1174-76 (auditor does not “guarantee” or “insure”

38 The language of the audit reports themselves supports this

interpretation by explicitly couching this particular statement

as an opinion. See Edward J. Goodman Life Income Trust v. Jabil

Circuit, Inc., 595 F. Supp. 2d 1253, 1281-82 (M.D. Fla. 2009).

But see In re OSG Sec. Litig., 971 F. Supp. 2d 387, 399

(S.D.N.Y. 2013) (whether statement is one of opinion cannot

“turn[ ] on th[e] semantic choice” of the maker).

accuracy of audited financial statements); see also Omnicare,

135 S. Ct. at 1325.

That an auditor’s assurances of GAAP compliance in the

audited statements is an opinion is clearly supported by the

auditing standards themselves, and by the very objective of an

audit “to express an opinion on the fairness, in all material

respects, with which a company’s financial statements present

the financial position, results of operations, and cash flows of

the company in conformity with GAAP.” In re WorldCom, 352 F.

Supp. 2d at 479-80.

For this reason, many courts have classified GAAP

compliance statements as opinions. See Deephaven, 454 F.3d at

1174-75; In re Colonial Bancgroup, 9 F. Supp. 3d at 1265;

Buttonwood, 2012 WL 2086607, at *2; Belmont Holdings Corp. v.

SunTrust Banks, Inc., 896 F. Supp. 2d 1210, 1229 n.17 (N.D. Ga.

2012); In re Lehman Bros., 799 F. Supp. 2d at 303; Edward J.

Goodman, 595 F. Supp. 2d at 1282. This is also the position

taken by Judge Mahan in the Oaktree litigation. See Oaktree II,

2014 WL 3816392, at *5; Oaktree I, 963 F. Supp. 2d at 1090.

As a preliminary matter, I find Miller has adequately

alleged with the specificity required by both the PSLRA and Rule

9(b) that the underlying assertion that Shengda’s 2008 and 2009

financial statements fairly represented Shengda’s financial

position in conformity with GAAP was materially false.39 2008

Audit Report; 2009 Audit Report. Contrast Oaktree I, 963 F.

Supp. 2d at 1087-88, 1090 (concluding that plaintiffs did not

adequately plead objective falsity of the GAAP conformance

statement to satisfy Rule 8, in part because they alleged that

financials were “vastly overstated” but did not provide accurate

numbers). The allegations demonstrate meaningfully different

revenue, sales, income, assets, and liability numbers in the AIC

filings of Shengda’s subsidiaries. They also demonstrate that

the banks at which Shengda purportedly had accounts held far

less cash – if any – on Shengda’s behalf than it had reported.

This is sufficient to satisfy the clarity and basis requirements

for these allegations. TAC ¶¶ 62-82. See Special Situations

Fund, 775 F. Supp. 2d at 237. Miller also adequately alleges

that Shengda violated GAAP by failing to disclose fully its

related-party transactions with SSCM, as required by Statement

39 In considering whether Miller’s pleadings are adequate, I

recognize Judge Tauro’s earlier determination in this case that

Miller had alleged sufficient facts to state a plausible claim

for relief under Massachusetts securities law against Morgan

Stanley, which included adequately alleging that Shengda had

made false and misleading statements in its 2008 and 2009 SEC

filings. See Miller, 879 F. Supp. 2d at 165. Judge Tauro

concluded that the allegations satisfied both Rule 8 and Rule

9(b) in asserting liability based on “a misstatement of material

facts that Defendants either knew, or in the exercise of due

diligence should have known.” Id. at 165-66.

of Financial Accounting Standards (“SFAS”) No. 57 and No. 850.

TAC ¶¶ 83-107.

To state a claim for § 18 liability, Miller must also plead

with specificity either that KPMG-HK did not sincerely believe

that Shengda’s financial statements conformed with GAAP at the

time it issued the audit reports, or that KPMG-HK omitted

material facts that made the statement of compliance misleading

to a reasonable investor in context. See Omnicare, 135 S. Ct.

at 1329-30; Plumber’s Union, 632 F.3d at 775. In other words,

the claim hinges on what KPMG-HK knew when it offered its

opinion on Shengda’s GAAP compliance.

Miller first points to Shengda’s frequent restatements to

posit that KPMG-HK was on notice that Shengda was not keeping

its books properly. TAC ¶¶ 206, 213-227. This proposition has

been rejected by the First Circuit as a basis for alleging

subjective falsity. See In re Credit Suisse, 431 F.3d at 49

(“[T]hat a speaker changes his or her mind and decides after the

fact that an earlier opinion was ill-advised is insufficient to

support an averment of subjective falsity.”).

Miller’s allegations that KPMG-HK knew about Shengda’s

ongoing relationship with SSCM, which was not fully disclosed in

Shengda’s 2007 financial statements as required by GAAP, fail to

establish subjective falsity for similar reasons. TAC ¶¶ 88-89,

92, 96-107, 208. As discussed above, the allegations show that

KPMG-HK took steps in conjunction with Shengda to ensure that

these related-party transactions were disclosed in the 2008

financial statements. TAC ¶¶ 100, 130, 209; id. ¶¶ 128-135,

145. Miller pleads that the 2008 Form 10-K did not disclose

that Shengda had previously falsely stated that SSCM was not a

related party; the pleadings also imply but do not explicitly

allege that Shengda did not issue an additional corrective

disclosure through a Form 8-K for its 2007 financial statements.

Id. ¶¶ 100, 102, 106. However, Miller does allege that the 2007

issues were identified by KPMG-HK to Shengda’s Audit Committee

and its management. Id. ¶¶ 130, 209. A restatement of the 2007

financial statements as required by SFAS No. 154 ¶¶ 25-26 could

be accomplished through disclosure in the 2008 Form 10-K or

through an alternative disclosure; this determination was the

responsibility of Shengda, perhaps in consultation with Hansen,

its 2007 auditor. In any event, Miller does not allege how this

failure to correct the 2007 error bore on compliance of

Shengda’s 2008 financial statements with GAAP. TAC ¶ 101; cf.

DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990)

(“Although accountants must exercise care in giving opinions on

the accuracy and adequacy of firms’ financial statements, they

owe no broader duty to search and sing. . . . Such a duty would

prevent the client from reposing in the accountant the trust

that is essential to an accurate audit.” (citation omitted)).

Miller next asserts that KPMG-HK’s awareness that Shengda

had poor internal controls over financial reporting, as

indicated in its correspondence to the Audit Committee on March

31, 2009 and in its 2008 internal control audit report, should

have alerted KPMG-HK to the likelihood that Shengda was

committing fraud. AU §§ 316.07, .85 (internal control problems

signal “an opportunity for a fraud to be perpetrated”). TAC

¶¶ 59, 183, 184, 209. But as discussed above, these allegations

go to whether KPMG-HK’s audit was sufficient under the PCAOB

standards, and do not establish that KPMG-HK had or should have

had specific knowledge that Shengda’s financial statements were

not GAAP-compliant.

Miller’s other allegations of KPMG-HK’s knowledge of

Shengda’s purportedly blatant fraudulent accounting practices do

not rise to the level of specificity required by the pleading

standards. The allegations here are similar to those in In re

Longtop:

At base, Lead Plaintiffs’ argument is that DTTC’s audit

reports contained material misstatements because they

erroneously certified that Longtop’s financials were

prepared in accordance with GAAP. No facts alleged show

that DTTC was aware, or should have been aware, of

wrongdoing on Longtop’s part at the time DTTC issued the

audit reports. Instead, the allegations in the

Complaint lead to the compelling and stronger inference

that DTTC performed a diligent audit, only to be duped

by Longtop’s fraud. Accordingly, Lead Plaintiffs have

failed to plead a material misstatement.

In re Longtop, 910 F. Supp. 2d at 581; see In re Puda Coal, 30

F. Supp. 3d at 259-60. Miller has not pled that KPMG-HK knew

enough at the time that it could not have believed its statement

of GAAP compliance, or that KPMG-HK failed to take critical

steps in its audit such that there is no reasonable basis on

which it could have believed that Shengda’s financial statements

complied with GAAP at the time it opined that they did. As the

First Circuit has acknowledged, “[s]imply pleading that the

defendant knew of the falsity, without providing any factual

basis for that knowledge, does not suffice.” Ezra Charitable

Trust v. Tyco Int’l, Ltd., 466 F.3d 1, 12-13 (1st Cir. 2006);

see In re Cabletron, 311 F.3d at 34.

c. Loss Causation

In order to survive a motion to dismiss on the one

statement I have found actionable — KMPG-HK’s statement of

compliance with PCAOB standards in conducting its internal

control audit — Miller must also adequately allege that its

losses were caused by this false statement. See 15 U.S.C.

§ 78u-4(b)(4) (plaintiff bears burden of proving that act or

omission “caused the loss for which the plaintiff seeks to

recover damages” (codifying § 21D(b)(4) of the Exchange Act)).

The First Circuit has declined to decide whether loss causation

must meet the heightened pleading standard of Fed. R. Civ. P.

9(b) or merely the basic standard of Fed. R. Civ. P. 8(a). See

Coyne, 943 F. Supp. 2d at 273 (citing Mass. Ret. Sys. v. CVS

Caremark Corp., 716 F.3d 229, 239 n.6 (1st Cir. 2013)). My own

view is that Rule 9(b) applies to allegations of loss causation;

therefore, a party must plead “with particularity the

circumstances constituting fraud,” even where, as here, scienter

is not required. See id. at 274.

To establish loss causation, a plaintiff must show “a

causal connection between the material misrepresentation and the

loss.” Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 342 (2005).

This means that the loss must be proximately caused “by a

disclosure that reveals something about the fraudulent

misstatement or omission.” In re Credit Suisse-AOL Sec. Litig.,

465 F. Supp. 2d 34, 46-47 (D. Mass. 2006) (citing Lentell v.

Merrill Lynch & Co., 396 F.3d 161, 173 (2d Cir. 2005)); In re

Polaroid Corp. Sec. Litig., 134 F. Supp. 2d 176, 188 (D. Mass.

2001). In other words, a plaintiff must “allege that it was the

subject of the omission or fraudulent statement that caused the

actual loss.” In re Credit Suisse, 465 F. Supp. 2d at 46

(citing Lentell, 396 F.3d at 173); see Dura Pharm., 544 U.S. at

344-45.

As a threshold matter, Miller has adequately pled a loss.

Miller purchased $8 million in bonds from what is now a bankrupt

company that cannot satisfy Miller’s claims in full. TAC ¶¶ 20-

21, 25, 29, 32, 243-244, 252-254. These securities have no

resale value. Id. ¶¶ 235-236, 248-250, 255. I find these

pleadings satisfactory. However, Miller has not alleged a

sufficient, specific causal connection between the loss and the

subject of the otherwise actionable omission.40 See Bricklayers,

752 F.3d at 86; In re Credit Suisse, 465 F. Supp. 2d at 47; see

also Lentell, 396 F.3d at 173; Suez Equity Inv’rs, L.P. v.

Toronto-Dominion Bank, 250 F.3d 87, 96 (2d Cir. 2001).

Miller primarily pursues a corrective disclosure theory,

that is, that “a corrective disclosure . . . led directly to a

drop” in the value of the bonds. In re Evergreen Ultra Short

Opportunities Fund Sec. Litig., 705 F. Supp. 2d 86, 95 (D. Mass.

2010). To establish loss causation based on an inflated

purchase price revealed by a disclosure, “the stock market must

have reacted to the subsequent disclosure of the misconduct,”

Bricklayers & Trowel Trades Int’l Pension Fund v. Credit Suisse

Secs. (USA) LLC, 752 F.3d 82, 86 (1st Cir. 2014), and not to a

“tangle of [other] factors affecting price,” such as “changed

40 Although I focus my analysis on the question of loss

causation, coincident with the parties’ briefing, I note that

the Third Amended Complaint seems unlikely to satisfy the

parallel requirement of transaction causation. See In re Credit

Suisse-AOL Sec. Litig., 465 F. Supp. 2d 34, 51-54 (D. Mass.

2006); see also Vanleeuwen v. Keyuan Petrochemicals, Inc., No.

CV 11-9495 PSG JCGZ, 2013 WL 2247394, at *19 (C.D. Cal. May 9,

2013). It would be difficult to conclude that Miller would not

have purchased the notes but for the single omission I have

found potentially actionable, particularly where other sections

of the 2008 Form 10-K appear to acknowledge issues with related-

party transactions. See, e.g., 2008 Form 10-K at 53.

investor expectations, [or] new industry-specific or firm-

specific facts, conditions, or other events.” Dura Pharm., 544

U.S. at 343. This “inflation-disclosure-deflation cycle” is a

common scenario – but not the only one – in which loss causation

may be established, provided the disclosure is sufficiently

connected to the misstatement or omission. See Bricklayers, 752

F.3d at 86; In re Charles Schwab Corp. Sec. Litig., 257 F.R.D.

534, 547 (N.D. Cal. 2009) (citing Dura Pharm., 544 U.S. at 346).

The corrective disclosure Miller identifies as the cause of

its loss is the March 15, 2011 Shengda press release. Miller

contends that immediately following this press release, the

Shengda bonds became illiquid, as evidenced by Miller’s own

attempt to sell shortly thereafter. TAC ¶¶ 25, 231, 234-235,

247-255. Even assuming that the loss can be tied to this

disclosure, which is arguably belied by other allegations in the

Third Amended Complaint,41 Miller has not identified a sufficient

41 The day before the March 15 press release, NASDAQ halted

trading in Shengda stocks after market close. TAC ¶ 230.

Miller acknowledges that the March 15 press release could not

have caused the trading halt, and speculates in its briefing –

without reference to pleaded facts – why the halt may have

occurred. On March 15, NASDAQ changed the reason for the halt,

and on June 10, NASDAQ suspended trading in Shengda stocks. Id.

¶¶ 230, 232, 235. These allegations demonstrate that there were

other market events that could have caused Miller’s loss, and —

because Miller has not alleged the reason for the halt (whether

publicly known or not) — prevent Miller from arguing that the

halt occurred as a result of KPMG-HK’s failure to disclose that

Shengda had a particular internal control deficiency. Cf.

Vanleeuwen, 2013 WL 2247394, at *19 (finding allegations

connection between this disclosure and the allegedly fraudulent

omission in the 2008 internal control audit report regarding

connecting trading halt to failure to disclose, coupled with

allegations that stock value decreased, sufficient to plead loss

causation even though precise issue that had been concealed was

not revealed until later).

In an attempt to salvage its § 18 claim, Miller now claims

– in argument, but not in its pleadings – that the actual loss

was not felt until Shengda’s announcement of default on the

bonds on June 9, the suspension of trading on June 10 (at which

point Miller surely could not sell the bonds), or Shengda’s

filing for bankruptcy on August 19, when the notes became due

and payable, in part because the bonds could have regained their

value before the date they came due, and Miller had an

investment strategy of holding corporate bonds to maturity.

Presumably, this argument is meant to attribute the loss to

other disclosures made between March 15 and August 10 by

Shengda, namely its May 5, 2011 Form 8-K and its May 5, 2011

press release explaining the reasons for KPMG-HK’s resignation

and identifying issues in the 2008 and 2009 audit reports and

with internal control deficiencies specifically. TAC ¶¶ 233-

234. Had Miller alleged that the loss followed these corrective

disclosures, Miller arguably would have demonstrated a

sufficient connection between the disclosure and the alleged

omission in the 2008 audit report regarding internal control

deficiencies (leaving aside the challenges of alleging causation

in light of the earlier NASDAQ changes).

But Miller has had numerous opportunities to amend its

complaint, and its pleadings clearly identify the March 2011

press release as the cause of the loss. See id. ¶¶ 25 (“When

ShengdaTech announced in mid-March 2011 that the 2010 audit had

raised red flags, the market for Plaintiffs’ bonds immediately

became illiquid. Plaintiffs were unable to sell their bonds

before ShengdaTech filed for bankruptcy in August 2011.”), 249-

250 (“Plaintiffs determined to sell their convertible bonds

virtually immediately after ShengdaTech’s initial announcement

that KPMG had encountered unexplained discrepancies in its audit

of ShengdaTech’s 2010 financial statements. . . . Then,

however, there was no liquid market for ShengdaTech’s

convertible bonds; thus, Plaintiffs could not sell their

bonds.”). Miller’s arguments when pressed in service of the

loss causation issue cannot serve to revise express language in

its pleadings.

internal control deficiencies. In the March 15 press release,

which is incorporated by reference into the Third Amended

Complaint, Shengda announced the appointment of a committee “to

investigate potentially serious discrepancies and unexplained

issues relating to [Shengda] and its subsidiaries’ financial

records” that KPMG-HK had identified “in the course of [its]

audit of the consolidated financial statements for fiscal year

ended December 31, 2010.” TAC ¶ 231; March 15, 2011 Press

Release. There are any number of “discrepancies and unexplained

issues” that could arise in financial statements, including ones

that impact the financial stability of the company and its

issued bonds, and ones that do not. Cf. Coyne, 943 F. Supp. 2d

at 275 (“There are potentially an infinite number of reasons why

a company’s financial returns might be ‘uncertain’ . . . .”).

In addition, the March 15 press release made no mention of

Shengda’s 2008 and 2009 financial statements or KPMG-HK’s audit

of them. March 15, 2011 Press Release; TAC ¶¶ 231, 234-235,

247-255.

The March press release, therefore, did not “reveal[ ] to

the market the pertinent truth that was previously concealed or

obscured by the company’s fraud,” Mass. Ret. Sys., 716 F.3d at

237 (citation omitted), that is, the undisclosed internal

control issues, or “reveal[] to the market that defendants’

[representations] were knowingly false.” In re Credit Suisse,

465 F. Supp. 2d at 45. Nor did it necessarily reveal that

Shengda’s financial status was not as robust as it had

represented. Cf. Mass. Ret. Sys., 716 F.3d at 240 (although

corrective disclosure need not contain “a direct admission that

a previous statement is untrue,” there must be some shared

subject matter between disclosure and misrepresentation such

that disclosure “as a whole, plausibly revealed [problems] to

the market”). The press release simply did not “connect the

current, present, negative information to the earlier false or

misleading statement.” Coyne, 943 F. Supp. 2d at 273. Contrary

to Miller’s suggestion otherwise, the March press release cannot

be said even to have “partially disclosed what the alleged

misrepresentations had concealed from the market.” Omanoff v.

Patrizio & Zhao LLC, No. 14-723, 2015 WL 1472566, at *6 (D.N.J.

Mar. 31, 2015) (quoting In re Bradley Pharm., Inc. Sec. Litig.,

421 F. Supp. 2d 822, 829 (D.N.J. 2006)).

It was not until after the March disclosure that the

specific concerns, and their relevance to earlier accounting

periods – including discrepancies in bank balances, supplier

transactions, VAT invoices, third-party sales and payments, and

customer information – were made known through the filing of a

Form 8-K in May 2011 and subsequent announcements by Shengda.

TAC ¶¶ 236-238, 251-253. Miller therefore cannot succeed on a

claim that it suffered a loss caused by the revelation to the

public of the specific misrepresentation or omission, because it

alleges that its loss occurred before that revelation. See In

re Daou Sys., Inc., 411 F.3d 1006, 1026-27 (9th Cir. 2005); see

also Urman v. Novelos Therapeutics, Inc., 867 F. Supp. 2d 190,

197 (D. Mass. 2012) (lack of temporal relationship between

change in stock price and public revelation of alleged

misrepresentation can defeat loss causation); cf. In re

Evergreen, 705 F. Supp. 2d at 95 (allegations that “[w]hen the

defendants’ alleged misstatements were ultimately revealed, the

[shares] declined in value, resulting in losses” were sufficient

to demonstrate loss causation). In placing the loss before the

identified disclosure, Miller has failed to “eliminat[e] other

possible explanations for th[e] price drop.” Mass. Ret. Sys.,

716 F.3d at 238 (citation omitted).

In the alternative, Miller argues that the March disclosure

was a materialization of a “zone of risk” that KPMG-HK’s

misrepresentation concealed. See Lentell, 396 F.3d at 173 (“a

misstatement or omission is the ‘proximate cause’ of an

investment loss if the risk that caused the loss was within the

zone of risk concealed by the misrepresentations and omissions

alleged by a disappointed investor”); In re Am. Int’l Grp., Inc.

2008 Sec. Litig., 741 F. Supp. 2d 511, 534 (S.D.N.Y. 2010).

Under this theory, the loss alleged must “be caused by the

materialization of the concealed risk.” Lentell, 396 F.3d at

173.

Whether this “zone of risk” theory is recognized in the

First Circuit is unresolved. See In re Credit Suisse, 465 F.

Supp. 2d at 47 & nn.13-14. But see Tutor Perini Corp. v. Banc

of Am. Sec. LLC, No. 11-10895-NMG, 2013 WL 5376023, at *20 (D.

Mass. Sept. 24, 2013). Even if it were, the March press release

did not disclose anything more than a possibility of a problem

with the 2010 financials. Cf. Stratte-McClure v. Morgan

Stanley, No. 09Civ.2017(DAB), 2013 WL 297954, at *12-13

(S.D.N.Y. Jan. 18, 2013), aff’d, 776 F.3d 94 (2d Cir. 2015).

Although Miller clearly perceived in March 2011 that it had

suffered a loss, a reasonable investor reading the press release

would not suspect, at least at the outset, that KPMG-HK had made

a misstatement in its 2008 internal control audit report that

was somehow tied to the loss.42 The allegations fail to

demonstrate a sufficient causal relationship between what KPMG-

HK’s omission hid – that it had identified a material weakness

not disclosed in its 2008 internal control audit report - and

Miller’s loss. See In re Lululemon Sec. Litig., 14 F. Supp. 3d

42 Similarly, a reasonable person reading the press release would

not connect the identified potential discrepancies in the 2010

financial statements to other potential misrepresentations by

KPMG-HK or by Shengda regarding its financial position in 2008

and 2009.

553, 587 (S.D.N.Y. 2014) (“The number of dots the Court must

connect to produce an adequate theory of loss causation are too

numerous and attenuated to succeed.”); see also Suez Equity, 250

F.3d at 96 (“[t]he loss causation inquiry typically examines how

directly the subject of the fraudulent statement caused the

loss”); cf. In re Credit Suisse, 465 F. Supp. 2d at 47 (loss

causation could be established by alleging that value of stock

declined after product failed to receive FDA approval if analyst

had concealed information suggesting that new product might not

receive approval).

In re Parmalat Securities Litigation, 375 F. Supp. 2d 278,

305-07 (S.D.N.Y. 2005), a case on which Miller relies, is

distinguishable here. In that case, the auditor similarly

issued reports certifying that the financial statements of

Parmalat fairly presented its financial position as of December

31, 2001. Id. at 306-07. However, the plaintiffs alleged that

these reports concealed “that Parmalat had massive undisclosed

debt and was unable to service it” – this was the concealed risk

that ultimately caused the plaintiffs’ loss. Id. at 307. The

parallels to the instant case end there. What happened next was

a direct materialization of the risk: Parmalat suffered a

liquidity crisis in December 2003 and could not pay the bonds as

they came due. Id. The very risk that the auditor had

concealed came to fruition. Trading in Parmalat securities was

suspended in Italy, followed by a sharp drop in prices of

Parmalat stock and bonds on other exchanges. Id. Although “the

true extent [of] the fraud was not revealed to the public until

February,” this was “immaterial where, as here, the risk

allegedly concealed by defendants materialized during that time

and arguably caused the decline in shareholder and bondholder

value.” Id.

In contrast to In re Parmalat, the foreseeable risks

theoretically concealed by KPMG-HK’s allegedly false statement

in its audit report – that Shengda would not have the resources

to pay its debts – were not what materialized in the March 2011

disclosure. Rather, that disclosure articulated potential

financial discrepancies, not inability to pay outstanding bonds,

years before the notes Miller held were to come due. While the

March disclosure may have been a contributor to the decline in

value and Miller’s loss, there is no identifiable connection

between this report and the omission in KPMG-HK’s 2008 internal

control audit report.43

43 Tutor Perini Corp. v. Banc of America Securities LLC, No. 11-

10895-NMG, 2013 WL 5376023 (D. Mass. Sept. 24, 2013), another

case on which Miller relies, is distinguishable for the same

reason. In that case, “the very risk that the defendants had

concealed from [the plaintiff] materialized: the market for the

[auction rate securities] held by [the plaintiff] collapsed.”

Id. at *21. The defendants had concealed, by way of misleading

statements, that there was an “increasingly severe risk of

illiquidity associated with such investments” and were

themselves “engaged in a strategy to reduce [their] own

Regardless of the theory Miller pursues, the Third Amended

Complaint does not plead or permit the inference that KPMG-HK’s

alleged violation of PCAOB standards, its failing to identify a

specific internal control deficiency in its 2008 internal

control audit report, “was a substantial factor in the decline”

in value of the bonds and a proximate cause of Miller’s loss.

In re Polaroid Corp., 134 F. Supp. 2d at 188-89. Accordingly,

regardless of Miller’s ability to plead and prove the falsity of

KPMG-HK’s statements, it has not adequately pled loss causation,

and its claim under § 18 must be dismissed.

B. Negligent Misrepresentation Claim

1. Pleading Requirements

Some but not all judges in this district have “clearly held

that Rule 9(b) applies to claims of negligent misrepresentation”

because the “same rule against pleadings on ‘information and

belief’ and the same policy against allowing ‘strike suits’

apply to negligent misrepresentation claims as apply to outright

claims of fraud.” In re Stratus Comput., Inc. Sec. Litig., No.

89-2075-Z, 1992 WL 73555, at *6 (D. Mass. Mar. 27, 1992); see

Advanced Card Sys., Inc. v. Hewlett-Packard Co., No. 1:04-CV-

12295, 2005 WL 6433203, at *5 (D. Mass. Oct. 28, 2004); Lindner,

inventory of [auction rate securities].” Id. at *1. Here, the

risk Miller allegedly concealed was not that Shengda could not

pay its issued bonds, but that it had an internal control issue

regarding related-party transactions.

880 F. Supp. at 57. But see Fed. Home Loan Bank of Bos. v. Ally

Fin., Inc., No. 11-10952-GAO, 2013 WL 5466631, at *1-2 (D. Mass.

Sept. 30, 2013) (concluding that Rule 9(b) does not apply to

negligent misrepresentation claims because they do not sound in

fraud).

My own view, as expressed above, is that Rule 9(b) applies

where the complaint and the claims overall sound in fraud, and

that a claim of negligent misrepresentation in this context so

sounds, even absent a scienter element. See Softub, Inc. v.

Mundial, Inc., 53 F. Supp. 3d 235, 256 (D. Mass. 2014); cf. N.

Am. Catholic Educ. Programming Found., Inc. v. Cardinale, 567

F.3d 8, 15 (1st Cir. 2009). Accordingly, I will apply Rule 9(b)

in assessing the pleadings.44

Under Massachusetts common law,45 a defendant is liable for

negligent misrepresentation “if in the course of his business,

he supplies false information for the guidance of others in

44 I am cognizant that, in an earlier motion to dismiss by Morgan

Stanley, Judge Tauro applied Rule 8 to the claim of a violation

of the Massachusetts securities law, which also does not require

scienter, in part because the complaint did not sound in fraud

in his view. See Miller, 879 F. Supp. 2d at 165-66.

Nonetheless, Judge Tauro concluded that the claims set forth in

the complaint “would be sufficient to satisfy Rule 9(b).” Id.

at 166. Accordingly, my application of Rule 9(b) does not

create internal inconsistencies in the legal standards imposed

in this case.

45 KPMG-HK does not dispute the application of Massachusetts law

solely for the purposes of resolving the motion to dismiss as

Miller has framed it.

their business transactions, causing and resulting in pecuniary

loss to others by their justifiable reliance on the information,

with failure to exercise reasonable care or competence in

obtaining or communicating the information.” Marram v. Kobrick

Offshore Fund, Ltd., 809 N.E.2d 1017, 1031 n.25 (Mass. 2004)

(citations omitted).

The statements at issue here are the same as those at issue

in the § 18 claim: KPMG-HK’s representations, in its 2008 and

2009 audit reports, first that it complied with the PCAOB

standards in conducting its audits, and second that Shengda

complied with GAAP in its financial statements.46 KPMG-HK

46 Although Miller attempts to pursue a claim based on statements

regarding Shengda’s 2010 quarterly financial statements

appearing in the December 2010 comfort letter from KPMG-HK to

Morgan Stanley, these statements are not actionable. Miller has

pled that KPMG-HK expressed awareness in the letter that

purchasers in the offering would rely on its opinions, but it

has not pled that the letter itself was intended to be or indeed

was provided to potential Shengda bond purchasers by Morgan

Stanley in the PPM. TAC ¶¶ 220-222, 268. Indeed, the letter,

which is incorporated by reference into the Third Amended

Complaint, is addressed to Morgan Stanley and several other

financial companies and indicates that the letter “is solely for

the information of the addressees” to assist in conducting an

investigation in connection with the securities offering, “and

it is not to be used, circulated, quoted or otherwise referred

to . . . for any other purpose, including, but not limited to,

the registration, purchase, or sale of securities.”

In addition, KPMG-HK’s consent to the use of its 2008 and

2009 audit opinions in preliminary registration statements

prepared for a proposed Shengda equity offering in 2010 that

never occurred is not actionable, because Miller was not a

purchaser of the inchoate offering and has not alleged how it

could have relied on the papers prepared for it. TAC ¶¶ 213,

219.

contends that Miller has not pled sufficiently particular facts

to establish that KPMG-HK provided false information, or that

KPMG-HK owed a duty to Miller such that Miller’s reliance on

KPMG-HK’s statements was justified.

2. False Information

KPMG-HK asserts that claims of negligent misrepresentation

under state common law must meet the same falsity standards as

§ 18 claims, and that Miller has failed to plead with

particularity that KPMG-HK’s audit opinions were false. Miller

does not dispute this proposition but instead contends, as

above, that KPMG-HK is incorrect in characterizing audit reports

as statements of opinion rather than fact.

Although not precisely aligned, there are sufficient

similarities between the falsity standards for negligent

misrepresentation and § 18 to warrant

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