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Oaktree Capital Management, L.P. v. KPMG

United States District Court, D. Nevada

August 5, 2013

OAKTREE CAPITAL MANAGEMENT, L.P., et al., Plaintiff(s),
v.
KPMG, et al., Defendant(s)

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[Copyrighted Material Omitted]

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[Copyrighted Material Omitted]

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For Oaktree Capital Management, L.P., Lazard Asset Management LLC, Angelo, Gordon & Co., L.P., Zazove Associates LLC, CNH Partners, LLC, Advent Capital Management, LLC, AQR Capital Management, LLC, Plaintiffs: Amanda J. Cowley, Gary R. Goodheart, LEAD ATTORNEYS, Fennemore Craig Jones Vargas, Las Vegas, NV; Brenda F. Szydlo, LEAD ATTORNEY, Grant & Eisenhofer P.A., New York, NY; Christine Mackintosh, Megan D. McIntyre, Stuart M. Grant, LEAD ATTORNEYS, PRO HAC VICE, Grant & Eisenhofer P.A., Wilmington, DE.

For Delaware Public Employees' Retirement System, Plaintiff: Brenda F. Szydlo, LEAD ATTORNEY, Grant & Eisenhofer P.A., New York, NY; ; Cynthia L. Collins, LEAD ATTORNEY, PRO HAC VICE, State of Delaware, Attorney General's Office, Wilmington, DE; Gary R. Goodheart, LEAD ATTORNEY, Fennemore Craig Jones Vargas, Las Vegas, NV; Ralph K Durstein, LEAD ATTORNEY, PRO HAC VICE, Delaware Department of Justice, Wilmington, DE.

For HFR CA Lazard Rathmore Master Trust, Consol Plaintiff: Amanda J. Cowley, Gary R. Goodheart, LEAD ATTORNEYS, Fennemore Craig Jones Vargas, Las Vegas, NV; Brenda F. Szydlo, LEAD ATTORNEY, Grant & Eisenhofer P.A., New York, NY; Christine Mackintosh, Megan D. McIntyre, Stuart M. Grant, LEAD ATTORNEYS, PRO HAC VICE, Grant & Eisenhofer P.A., Wilmington, DE.

For KPMG, Defendant: Donald J. Campbell, J. Colby Williams, LEAD ATTORNEYS, Campbell & Williams, Las Vegas, NV; Edward S Kim, LEAD ATTORNEY,,Bingham McCutchen Costa Mesa, CA; Jeffrey Q. Smith, LEAD ATTORNEY, PRO HAC VICE, Bingham McCutchen LLP, New York, NY.

For KPMG International Cooperative, Defendant: Aaron D. Shipley, LEAD ATTORNEY, McDonald Carano Wilson LLP, Las Vegas, NV; Andrew P Gordon, LEAD ATTORNEY, McDonald Carano Wilson, Las Vegas, NV; Kenneth M Katz, William R Maguire, Yoshinori M. Sasao, LEAD ATTORNEYS, PRO HAC VICE, Hughes Hubbard & Reed LLP, New York, NY.

For KPMG LLP, Defendant: Christopher G Rigler, LEAD ATTORNEY, John H. Cotton & Associates, Ltd., Las Vegas, NV; John H. Cotton, LEAD ATTORNEY, Cotton & Associates, Las Vegas, NV; John K. Villa, LEAD ATTORNEY, PRO HAC VICE, Williams & Connolly LLP, Washington, DC; Kevin M. Hodges, William Pruitt Ashworth, LEAD ATTORNEYS, Williams & Connolly LLP, Washington, DC.

For Hansen, Barnett & Maxwell, P.C., Defendant: Benjamin Tulis, Peter Larkin, William Kelly, LEAD ATTORNEYS, PRO HAC VICE, Wilson Elser Moskowitz Edelman & Dicker, LLP, White Plains, NY; David S. Kahn, LEAD ATTORNEY, Weinberg Wheeler Hudgins Gunn & Dial, LLC, Las Vegas, NV; Kathleen M. Maynard, Wilson, Elser, Moskowitz, Edelman & Dicker LLP, Las Vegas, NV.

For Morgan Stanley & Co., Defendant: John P Bueker, Randall W Bodner, LEAD ATTORNEYS, PRO HAC VICE, Ropes & Gray LLP, Boston, MA; Lucy C Hynes, LEAD ATTORNEY, PRO HAC VICE, Ropes & Gray LLP, Washington, DC; Mark G. Krum, Matthew W Park, LEAD ATTORNEYS, Lewis and Roca LLP, Las Vegas, NV.

OPINION

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ORDER

JAMES C. MAHAN, UNITED STATES DISTRICT JUDGE.

Presently before the court are defendants KPMG, a Hong Kong Partnership (" KPMG HK" ); KPMG International Cooperative (" KPMG Int'l" ); KPMG LLP (" KPMG US" ); Hansen, Barnett, and Maxwell, P.C. (" Hansen" ); and Morgan Stanley & Co.'s (" Morgan Stanley" ) respective motions to dismiss pursuant to Federal Rules of Civil Procedure 12(b)(6) and 12(b)(1). (Docs. # 124, 126, 127, 128, 129). Plaintiffs Oaktree Capital Management, L.P. (" Oaktree" ); Lazard Asset Management LLC (" Lazard" ); Angelo, Gordon, and Co., L.P. (" Angelo" ); Zazove Associates LLC (" Zazove" ); CNH Partners, LLC (" CNH" ); Advent Capital Management, LLC (" Advent" ); AQR Capital Management, LLC (" AQR" ); HFR CA Lazard Rathmore Master Trust (" HFR" ); and Delaware Public Employee Retirement System (" DPERS" ) filed a consolidated response in opposition to the motions. (Doc. # 137). Each defendant then filed a reply. (Docs. # 141, 142, 143, 145, and 146).

I. BACKGROUND

A. ShengdaTech

The claims presented in plaintiffs' consolidated complaint (doc. # 120) [1] rest on allegedly false material statements in Securities and Exchange Commission (" SEC" ) filings and offering memoranda. The documents were issued by a corporation called ShengdaTech (" Shengda" ). Plaintiffs purchased securities issued by Shengda. Plaintiffs are either investment funds or investment managers. Defendants are auditors and underwriters that Shengda retained in connection with the preparation of the documents. Shengda, now bankrupt, is not a party to this suit.

According to a Shengda offering memorandum, Shengda is a Nevada corporation with its principal place of business in the People's Republic of China (" China" ). (Doc. # 130, Ex. C, 3). [2] Prior to its

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bankruptcy, Shengda manufactured a chemical additive called nano-precipitated calcium carbonate (" NPCC" ). ( Id. at 1). The additive is used to strengthen certain industrial materials such as paint, plastic, and rubber. ( Id. ).

Faith Bloom Limited (" Faith Bloom" ) is a holding company organized in the British Virgin Isles. ( Id. at 3). Faith Bloom is a wholly owned subsidiary of Shengda. ( Id. ). In turn, Faith Bloom wholly owns five manufacturing companies operating and organized in China (the " PRC companies" ). [3] ( Id. ). The PRC companies carry out the manufacturing, marketing, and sale of NPCC and other coal-based chemicals on behalf of Faith Bloom and Shengda. ( Id. ).

Shengda, once a publicly traded corporation registered with the SEC, was formed by the process of reverse merger. Reverse mergers are complex corporate transactions utilized by private companies who wish to gain access to U.S. capital markets, but also wish to avoid the expensive and drawn-out process of SEC registration. Formally, the target company, a publicly traded and usually asset-less corporation, acquires the private company, generally through a share exchange agreement. Practically however, the private company is the acquirer, as it is the private company's management and board that will eventually control and operate the surviving company.

On March 31, 2006, Faith Bloom and the Zeolite Exploration Company (" Zeolite" ), a Nevada corporation, consummated a share exchange agreement, pursuant to a securities purchase agreement and a plan of reorganization. ( Id. ). Under the agreement, Faith Bloom became a wholly-owned subsidiary of Zeolite. ( Id. ). Faith Bloom's management had successfully taken over Zeolite through the reverse merger process. Effective January 3, 2007, Zeolite, by and through its new management, changed its name to ShengdaTech, Inc. ( Id. ). Shengda's stock began trading on the NASDAQ stock exchange in 2007. (Doc. # 120, 15).

B. Shengda's note offerings and subsequent default

In an effort to raise capital, Shengda first conducted a debt offering in 2008, selling $115,000,000 par amount of 6.0% debt notes (the " 6.0% offering" ). The notes were offered to " qualified institutional buyers," which are defined by rule 144A-a regulation promulgated under the Securities Act of 1933. 17 C.F.R. § 230.144A(a)(1). The investment manager plaintiffs are qualified institutional buyers who purchased the notes on behalf of their funds and clients. The notes were solicited via an offering memorandum (the " 6.0% memo" ).

The 6.0% memo contained Shengda's audited 2007 financial statements, which included defendant Hansen's unqualified audit

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opinions. Plaintiffs allege that Hansen consented to the inclusion of its opinion in the 6.0% memo. Plaintiff CNH purchased 6.0% notes on behalf of its funds both through the offering and on the secondary market. Plaintiffs Lazard, HFR, and AQR purchased 6.0% notes on the secondary market on behalf themselves, their clients, or their funds.

Shengda later conducted a second notes offering, this time with a rate of 6.5%. On December 10, 2010, Shengda announced that Morgan Stanley would be underwriting $130,000,000 of 6.5% notes to be issued by Shengda (the " 6.5% offering" ). A condition of the offering was that Shengda would repurchase at least 75% of the 6.0% notes. Again, the notes were solicited to qualified institutional buyers via an offering memorandum (the " 6.5% memo" ).

The 6.5% memo contained audited financial statements for 2007, 2008, and 2009, as well as unaudited financial statements for 2010. The 2007 financial statements included defendant Hansen's unqualified audit opinion for that year. The 2008 and 2009 financial statements included defendant KPMG HK's unqualified audit opinions for those years. Plaintiffs allege that Hansen and KPMG HK consented to the inclusion of their respective statements in the 6.5% memo. All plaintiffs purchased 6.5% notes through the 6.5% offering on behalf of themselves, their clients, or their funds. Plaintiffs Oaktree, Lazard, Angelo, AQR, HFR, and DPERS purchased additional notes on the secondary market. On December 15, 2010, Shengda announced that the 6.5% offering had been completed.

Since that time, plaintiffs have come to the uncomfortable conclusion that " ShengdaTech has turned out to have been a sham." (Doc. # 120, 17). This does not seem to be in dispute between the parties. Plaintiffs allege that " ShengdaTech management utterly misrepresented the value and, indeed, the existence of material assets that were recorded on the [c]ompany's balance sheet, and materially overstated the [c]ompany's sales by recording unsupported and fictitious transactions." ( Id. )

On March 15, 2011, revelations of management's allegedly long-standing fraudulent conduct began. Shengda announced that its board of directors (the " board" ) had appointed a special committee to investigate " discrepancies" and " unexplained issues relating to the [c]ompany's . . . financial records" that KPMG HK unearthed in its preparation of an audit opinion on Shengda's 2010 financial statements. These revelations culminated on May 5, 2011, when Shengda filed a form 8-K with the SEC.

First, the form 8-K indicated that KPMG HK believed its audit opinions regarding the 2008, and 2009, financial statements should no longer be relied on by investors. Secondly, the 8-K divulged more specific information about the discrepancies and issues initially raised by KPMG:

concerns included serious discrepancies and unexplained issues relating to, among others: (I) the [c]ompany's bank balances; (ii) transactions with major suppliers; (iii) VAT invoices and payments; (iv) sales and payments for sales by third parties; (v) sales to the [c]ompany's second largest customer; (vi) discrepancies between KPMG HK's direct calls to customers and confirmations returned by mail; and (vii) concerns raised by directly confirming customer sales and accounts receivables.

(Doc. # 120, 20).

The Shengda notes allegedly traded at or above $96 for the two weeks prior to the March 15, 2011, disclosure. The price allegedly fell about 15% to $82 the following week. After the May 5, 2011, disclosure, plaintiffs contend that the notes continued

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to decline in value, dropping into the " $70 range."

On June 9, 2011, Shengda filed a form 8-K with the SEC, announcing, inter alia, that it would be defaulting on the 6.0% notes. A week later, Shengda failed to make interest payments owed to holders of the 6.5% notes. On August 19, 2011, Shengda began bankruptcy proceedings in the United States Bankruptcy Court for the District of Nevada. A few days later, Shengda acknowledged, via another form 8-K, that filing for bankruptcy was an event of default for both the 6.0% notes and the 6.5% notes.

C. Defendants

KPMG HK is the Hong Kong member firm of KPMG Int'l and provides professional financial services to Hong Kong-based clients. Shengda retained KPMG HK to audit its 2008, and 2009, financial statements in preparation for its SEC filings. Plaintiffs allege that KPMG HK expressly consented to the inclusion of its audit opinion in Shengda's 2008 SEC form 10-K (" 2008 10-K" ), its 2009 SEC form 10-K (" 2009 10-K" ), its 2009 SEC form 10-K/A (" 2009 10-K/A" ), and the 6.5% memo.

KPMG Int'l is a cooperative organized under Swiss law. It is the international liaison for member firms bearing the KPMG name and operating in different countries around the globe. KPMG member firms provide professional financial services to clients around the world. KPMG Int'l has 54 member firms that provide services in 150 countries. Plaintiffs allege, and defendants deny, that KPMG Int'l dominates and controls KPMG HK.

KPMG U.S. is the United States (" US" ) member firm of KPMG Int'l and provides professional financial services to clients in the U.S. and coordinates with member firms in other countries whose clients are subject to U.S. regulation. Plaintiffs allege, and defendants deny, that KPMG U.S. dominates and controls both KPMG HK and KPMG Int'l.

Defendant Hansen is a firm based in Utah that provides professional financial services. Shengda retained Hansen to audit its 2007, financial statements for inclusion in SEC filings. Plaintiffs allege that Hansen expressly consented to the inclusion of its audit opinion in Shengda's 2007 SEC form 10-K/A, the 6.0% memo, and the 6.5% memo.

Defendant Morgan Stanley is a large financial institution headquartered in New York. One of the many financial services Morgan Stanley offers is the underwriting of private debt offerings. In that capacity, Morgan Stanley purchased $130,000,000 par value of 6.5% notes and offered those notes to qualified institutional buyers via the 6.5% offering. Plaintiffs allege that Morgan Stanley failed to conduct a reasonable investigation into the accuracy of Shengda's financial statements and thereby breached a duty to plaintiffs.

D. Plaintiffs and plaintiffs' claims for relief

Plaintiffs are either investment managers or investment funds. Plaintiff Oaktree is an asset management firm based in California. Plaintiffs Lazard, Angelo, and Advent are New York-based asset management firms. Plaintiffs CHN and AQR are Connecticut-based asset management firms, [4] and plaintiff Zazove is a Nevada-based asset management firm. Plaintiff HFR is an investment fund organized under Bermuda law and managed by plaintiff Lazard. Plaintiff DPERS is a pension fund in Delaware advised by plaintiff Oaktree.

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The fund plaintiffs, HFR and DPERS, are funds managed by other plaintiffs, Lazard and Oaktree respectively, and are suing on behalf of themselves. The investment company plaintiffs are suing on behalf of funds that these plaintiffs manage or co-manage, or on behalf of these plaintiffs' clients who they advise and whose accounts they manage. Plaintiffs have alleged that they possess valid assignments of the claims stemming from purchases made by clients.

Plaintiffs collectively purchased $56.6 million par value of 6.5% notes through the 6.5% offering. They also collectively purchased another $16.265 million par value of 6.5% notes on the secondary market, $250,000 par value of 6.0% notes through the 6.0% offering, and $21.775 million par value of 6.0% notes on the secondary market. Some of these notes were sold at a significant discount after Shengda's March 15, 2011 announcement, but plaintiffs continue to hold the majority of the allegedly worthless debt.

Plaintiffs allege that the series of disclosures and bankruptcy filings made by Shengda in 2011 support an inference of a long history of fraudulent reporting by Shengda management. Plaintiffs contend that Shengda management's fraudulent practices were manifested in materially overstated figures in financial statements as far back as 2007.

Plaintiffs allege 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 generally accepted accounting principles (" GAAP" ); and falsely opined that Shengda's " internal controls" were sufficient. Plaintiffs allege that defendants consented to the inclusion of these false statements in several of Shengda's SEC filings.

Plaintiffs make other allegations supporting inferences that KPMG HK and Hansen were negligent and ignored red flags that should have prompted a more inquisitive probe into Shengda's finances and reporting. Plaintiffs allege that defendant Morgan Stanley failed to reasonably investigate the audited 2008 and 2009 statements or perform appropriate due diligence on the unaudited 2010 statements. They argue that by attaching its name to the 6.5% memo without performing these investigations, Morgan Stanley provided a misleading " imprimatur of legitimacy" to the notes and should incur liability for the accuracy of the statements.

Beyond the 2011 Shengda disclosures described above, plaintiffs allege other facts they argue support an inference of falsity in the financial statements included in Shengda's SEC filings and offering memoranda. For instance, plaintiffs allege that there were discrepancies between Shengda's SEC filings and the Chinese companies' filings with China's Administration of Industry and Commerce (the " AIC" ). Plaintiffs suggest that these discrepancies were so large that differences in accounting standards or principles could not possibly explain the disjunct figures.

Plaintiffs also allege that management in China obstructed the special committee's chief restructuring officer Michael Kang's (" CRO Kang" ) attempts to verify accounts and obtain information on the assets and operations of the PRC companies. A number of Shengda filings in U.S. Bankruptcy Court indicate that this was the case. See Adversary Proceeding Complaint filed on August 20, 2011, in In re ShengdaTech, Inc., Case No. BK-11-52649, Adv. Pr. No. 11-05082, doc. # 1, pp. 2, 6 (Bankr. D. Nev.). [5]

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The bankruptcy filings indicate that despite this obstructionism, the special committee discovered that certificates of deposit (" CDs" ) reported in the financial statements could not be verified by the banks that purportedly issued them. Id. at 6. CRO Kang allegedly discovered that bank accounts held by Faith Bloom and reported by Shengda to contain US$73 million on December 31, 2010, in fact held only $50,000 collectively. See Disclosure Statement filed May 16, 2012, in In re ShengdaTech, Inc., Case No. BK-11-52649, doc. # 468, 28. Plaintiffs maintain that these discrepancies are sufficiently significant to support an inference that the fraudulent conduct must have been going on for years.

Each plaintiff contends that it read and relied upon the 6.0% memo and the 6.5% memo in making its decisions to purchase the respective notes. [6] Specifically, plaintiffs allege reliance on the financial statements and defendants KPMG HK and Hansen's audit opinions. In addition to the statements in the offering memoranda, plaintiffs allege reliance on a number of Shengda's SEC filings and defendants KPMG HK and Hansen's audit opinions therein: the 2007 10-K/A, the 2008 10-K, the 2009 10-K/A, and the 2009 10-K.

Plaintiffs submit eleven claims for relief. Each claim arises under one or more of the following: § 18 or § 20 of the 1934 Securities Exchange Act (the " Exchange Act" ), the California Corporations Code, the Connecticut Uniform Securities Act, or common law principles. Each claim rests on plaintiffs' allegations that they justifiably relied on financial statements and audit opinions in Shengda's SEC filings and offering memoranda, which contained materially false statements negligently endorsed by defendants KPMG HK, Hansen, or Morgan Stanley, or some combination of those defendants. Plaintiffs claim that defendants KPMG USA and KPMG Int'l are liable under statutory theories of " control person liability" and the common law theory of respondeat superior. (Doc. # 120).

II. LEGAL STANDARDS

A. Rule 8

A court may dismiss a plaintiff's complaint for " failure to state a claim upon which relief can be granted." Fed.R.Civ.P. 12(b)(6). A properly pled complaint must provide " [a] short and plain statement of the claim showing that the pleader is entitled to relief." Fed.R.Civ.P. 8(a)(2); Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 555, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007). While Rule 8 does not require detailed factual allegations, it demands " more than labels and conclusions" or a " formulaic recitation of the elements of a cause of action." Ashcroft v. Iqbal, 556 U.S. 662, 129 S.Ct. 1937, 1949, 173 L.Ed.2d 868 (2009) (citation omitted).

" Factual allegations must be enough to rise above the speculative level." Twombly, 550 U.S. at 555. Thus, to survive a motion to dismiss, a complaint must contain sufficient factual matter to " state a claim to relief that is plausible on its face." Iqbal, 129 S.Ct. at 1949 (citation omitted).

In Iqbal, the Supreme Court clarified the two-step approach district courts are to apply when considering motions to dismiss. First, the court must accept as true

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all well-pled factual allegations in the complaint; however, legal conclusions are not entitled to the assumption of truth. Id. at 1950. Mere recitals of the elements of a cause of action, supported only by conclusory statements, do not suffice. Id. at 1949.

Second, the court must consider whether the factual allegations in the complaint allege a plausible claim for relief. Id. at 1950. A claim is facially plausible when the plaintiff's complaint alleges facts that allows the court to draw a reasonable inference that the defendant is liable for the alleged misconduct. Id. at 1949.

Where the complaint does not permit the court to infer more than the mere possibility of misconduct, the complaint has " alleged - but not shown - that the pleader is entitled to relief." Id. (internal quotations omitted). When the allegations in a complaint have not crossed the line from conceivable to plausible, plaintiff's claim must be dismissed. Twombly, 550 U.S. at 570.

The Ninth Circuit addressed post- Iqbal pleading standards in Starr v. Baca, 652 F.3d 1202, 1216 (9th Cir. 2011). The Starr court stated, " First, to be entitled to the presumption of truth, allegations in a complaint or counterclaim may not simply recite the elements of a cause of action, but must contain sufficient allegations of underlying facts to give fair notice and to enable the opposing party to defend itself effectively. Second, the factual allegations that are taken as true must plausibly suggest an entitlement to relief, ...


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