Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 1 of 18

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1 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 1 of 18 UNITED STATES DISTRICT COURT EASTERN DISTRICT OF NEW YORK X BARRY BLANK, WILLIAM D. WITTER PARTNERS, LP, ROBERT D. HERPST, and DAVID HUST, CAROL HABA, on behalf of themselves and all others similarly situated, -against- Plaintiffs, MEMORANDUM AND ORDER 03-CV-2111 (JS)(MLO) VICTOR JACOBS, HERMAN JACOBS, DAVID SHAMILZADEH, JACK JACOBS, JEFFREY RABINOVICH, SOL NAIMARK, JEFFREY BERG, STUART GLASSER, KPMG LLP, MAYER RISPLER & COMPANY, P.C., and ARTHUR ANDERSEN LLP, Defendants. X Appearances: For Plaintiffs: Stephen T. Rodd, Esq. Meagan A. Zapotocky, Esq. Abbey Gardy, LLP 212 East 39th Street New York, New York For Defendants: Victor Jacobs, Steven G. Schulman, Esq. Herman Jacobs, Milberg Weiss Bershad & Schulman LLP David Shamilzadeh, One Pennsylvania Plaza Jack Jacobs, and New York, New York Jeffrey Rabinovich Sol Naimark, Gregory G. Ballard, Esq. Jeffrey Berg, and Cadwalader, Wickersham & Taft, LLP Stuart Glasser 100 Maiden Lane New York, New York KPMG Kevin A. Burke, Esq. Heller, Ehrman, White & McAuliffe, LLP Times Square Tower 7 Times Square New York, New York

2 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 2 of 18 Mayer, Rispler Benjamin Zelermyer, Esq. Steinberg & Cavaliere, LLP 50 Main Street, Suite 901 White Plains, New York Arthur Andersen Christopher R. Harris, Esq. Robert J. Malionek, Esq. Latham & Watkins, LLP 885 Third Avenue New York, New York SEYBERT, District Judge: On September 17, 2004, this Court issued an Order ( September Order ) dismissing Plaintiffs class action securities fraud claims against Defendants Mayer Rispler & Company ( Mayer Rispler ), KPMG LLP ( KPMG ), and Arthur Andersen LLP ( Andersen ) (collectively the Auditor Defendants ), as well as Defendants Sol Naimark ( Naimark ), Jeffrey Berg ( Berg ) and Stuart Glasser ( Glasser ) (collectively the Outside Director Defendants ) because Plaintiffs failed to adequately allege that Defendants acted with scienter. On October 18, 2004, Plaintiffs filed a Second Consolidated Amended Class Action Complaint ( Second Consolidated Complaint), ostensibly remedying the defects of its predecessor. Pending before the Court are the Auditor Defendants and the Director Defendants motions to dismiss the Second Consolidated Complaint. 2

3 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 3 of 18 BACKGROUND This securities class action arises under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78(j)(b) ( Exchange Act ) and Rule 10b-5, 17 C.F.R b-5. The class period is from June 22, April 9, 2003 ( Class Period ). The pertinent facts of this case have already been set forth in the Court s September Order. The following provides a refresher. The facts are taken from the Second Consolidated Complaint, and are presumed to be true for the purposes of this motion. Allou Healthcare, Inc. ( Allou ) was, during the class period, publicly traded on the American Stock Exchange ( AMEX ). Allou was a manufacturer and distributor of, inter alia, health and beauty products. Plaintiffs allege that, during the class period, Allou s finances were not accurately depicted due to a fraudulent scheme perpetrated by Defendants Victor Jacobs, Herman Jacobs, Jack Jacobs, David Shamilzadeh, and Jeffrey Rabinovich (collectively, the Individual Defendants ). The Individual Defendants were officers and directors of Allou. In June 2004, several of the Individual Defendants were indicted on criminal charges arising from their alleged fraudulent conduct. The Fraud The alleged fraud dates back to the mid-1990s. (2d Consol. Compl. 42.) The Individual Defendants fraudulent scheme 3

4 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 4 of 18 involved the use of a system of computer passwords that, in effect, created two sets of financial books for Allou. (Id ) Allou s computer system permitted the participants in the fraudulent scheme to create fictitious sales and inventory transactions through the use of a fictitious employee, Salesman No. 2." (Id ) Secret computer passwords for certain files allowed the Individual Defendants to hide the bogus transactions from Allou employees. The Individual Defendants used Salesman No. 2 to create millions of dollars in non-existent merchandise sales. (Id ) Specifically, Plaintiffs allege that Salesman No. 2 netted Allou $220 million in bogus sales between January 2000 and March The fraudulent scheme also involved sham inventory purchase transactions involving related entity counter-parties, manipulation of costs of inventory to impact earnings, and improper diversion of cash from Allou to the Individual Defendants. (Id ) These fraudulent transactions led to a distorted financial picture of Allou. For example, according to Plaintiffs, Allou s revenues, inventory, accounts receivable, net worth and earnings were all overstated. The Auditor Defendants The Auditor Defendants, at different times during the Class Period, served as Allou s independent auditor. Mayer Rispler 4

5 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 5 of 18 was Allou s auditor until April (2d Consol. Compl. 29.) Andersen replaced Mayer Rispler, and served as Allou s auditor until some time in (Id. 30.) KPMG replaced Andersen as auditor in June 2002, when Andersen lost its auditing license. (Id. 145.) KPMG has served as Allou s auditor from 2002 to the present. (Id. 32.) The Auditor Defendants issued opinion letters indicating that Allou s financial statements were audited in compliance with Generally Accepted Accounting Standards ( GAAS ) and that the financial statements fairly presented the financial position of Allou in conformity with Generally Accepted Accounting Principles ( GAAP ). (See 2d Consol. Compl. 74, 76, 78, 80.) The financial statements were used in Allou s Securities Exchange Commission ( SEC ) filings, including 10-K and 10-Q Reports. Plaintiffs allege that the financial statements disseminated to the public through Allou s SEC filings were materially false and misleading because the financial statements overstated Allou s revenues, inventory, accounts receivable, net worth and earnings, and failed to disclose Allou s numerous related party transactions with entities owned by certain of the Individual Defendants. (Id. 85.) The Plaintiffs charge the Auditor Defendants with violating GAAS and otherwise recklessly disregarding the fraud at Allou. (Id.) 5

6 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 6 of 18 The Outside Director Defendants The Outside Director Defendants are Jeffrey Berg ( Berg ), Stuart Glasser ( Glasser ), and Sol Naimark ( Naimark ). Each Outside Director Defendant served as a non-officer, nonemployee member of Allou s Board of Directors (the Board ). The Outside Director Defendants served on the Board s Audit Committee during the Class Period. (2d Consol. Compl. 25.) As members of the Audit Committee, the Outside Director Defendants were responsible for reviewing and signing Allou s SEC filings. Plaintiffs allege that, because of the immense degree of fraud at Allou, it is reasonable to infer that the Outside Director Defendants either knew of, or were willfully blind to the Individual Defendants fraud. Plaintiffs claim that the Outside Director Defendants may be held liable under the securities laws for knowingly or recklessly causing to be disseminated to the public information that was materially false and misleading. (Id ) Unraveling The Fraud In September 2002, Allou announced that a fire at its Brooklyn warehouse had destroyed much of its inventory. In November 2002, it was later determined that officials had declared the fire suspicious. (2d Consol. Compl. 56.) In March 2003, one of Allou s lenders noticed 6

7 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 7 of 18 discrepancies in the financial figures that Allou had been providing to it. (Id. 57.) In response, The company retained RAS Management Advisors ( RAS ), a crisis management and turnaround firm to review Allou s inventory and accounts receivable. RAS determined that Allou executives had fabricated approximately $220 million in sales and claimed nearly $200 million in non-existent inventory. (Id. 58.) On April 9, 2003, Allou s lenders forced Allou into bankruptcy. Trading of Allou stock was halted that day. Plaintiffs Claims Relying upon the fraud on the market theory, Plaintiffs contend that they purchased Allou stock at artificially inflated prices. Plaintiffs have filed claims pursuant to the Exchange Act, Sections 10(b) and 20 (a). DISCUSSION I. Standard Of Review As set forth in this Court s September Order, a district court should grant a motion to dismiss under Rule 12(b)(6) of the Federal Rules of Civil Procedure only if it is clear that no relief could be granted under any set of facts that could be proved consistent with the allegations. H.J. Inc. v. Northwestern Bell Tel. Co., 492 U.S. 229, , 109 S. Ct. 2893, 106 L. Ed. 2d 195 (1989) (quoting Hishon v. King & Spaulding, 467 U.S. 69, 73, 104 S. Ct. 2229, 81 L. Ed. 2d 59 (1984)). The Court must read the facts 7

8 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 8 of 18 alleged in the complaint in the light most favorable to the plaintiff, and accept these allegations as true. Id. at 249; See also Leatherman v. Tarrant County Narcotics Intelligence and Coordination Unit, 507 U.S. 163, 165, 113 S. Ct. 1160, 122 L. Ed. 2d 517 (1993) (citing the Federal Rules liberal system of notice pleading). II. Violations Of Rule 10b-5 In order to state a claim for violation of Rule 10b-5, a plaintiff must plead (1) that the defendant made, directly or indirectly, one or more misrepresentations or omissions; (2) in connection with the purchase or sale of a security; (3) that were material; (4) and involved interstate commerce; (5) and that the defendant acted with scienter. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 201, 96 S. Ct. 1375, 1385, 47 L. Ed. 2d 668, 681 (1976). A complaint asserting securities fraud must also satisfy the heightened pleading requirement of Federal Rule of Civil Procedure 9(b), which requires fraud to be alleged with particularity. See Ganino v. Citizens Utilities Co., 228 F.3d 154, 168 (2d Cir. 2000) ; F ED. R. CIV. P. 9 (b) ("In all averments of fraud... the circumstances constituting fraud... shall be stated with particularity."). Moreover, a complaint asserting securities fraud must satisfy the requirements of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. 78u-4(b) ( PSLRA ). In 1995, Congress enacted the PSLRA, imposing heightened pleading 8

9 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 9 of 18 requirements for plaintiffs in securities fraud actions. Specifically, in the context of a securities action based upon allegedly misleading statements or omissions, the PSLRA provides that: the complaint shall 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. the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind 15 U.S.C. 78u-4 (b) (2). In the context of a 10b-5 action, scienter means a mental state embracing intent to deceive, manipulate, or defraud. Ernst & Ernst, 425 U.S. at 193 n.12; see also Kalnit v. Eichler, 264 F.3d 131, 138 (2d Cir. 2001); In re Scholastic Corporation Securities Litigation, 252 F.3d 63, 76 (2d Cir. 2001). The Supreme Court has held that mere negligence will not support liability under Rule 10b-5. See Ernst & Ernst, 425 U.S. at 193, 96 S. Ct. at 1381, 47 L. Ed. 2d 668 (holding that negligence alone is insufficient for civil liability under 10b-5 and instead that some level of scienter intent to deceive, manipulate or defraud is required). The Supreme Court has, however, left open the issue of whether or not recklessness will suffice to support 10b-5 9

10 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 10 of 18 liability. The law in this Circuit firmly establishes that recklessness is indeed sufficient to support 10b-5 liability. See In re Scholastic, 252 F.3d at 76; Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38, 46 (2d Cir. 1978) ( [I]t is consistent with, if not demanded by, precedent in this circuit to hold that reckless conduct satisfies the scienter requirement. ); Lanza v. Drexel & Co., 479 F.2d 1277, 1301 (2d Cir. 1973); Chill v. Gen. Elec. Co., 101 F.3d 263, (2d Cir. 1996). To qualify as reckless conduct, [a defendant s] conduct must have been highly unreasonable and an extreme departure from the standards of ordinary care... to the extent that the danger was either known to [the defendant] or so obvious that [he] must have been aware of it. In re Scholastic, 252 F.3d at 76 (quoting Rolf, 570 F.2d at 47). This rather inexact standard of conduct has been applied to a variety of fact patterns and courts have enunciated various patterns of behavior which could be classified as reckless. The Rolf court held that [a] refusal to see the obvious, a failure to investigate the doubtful, if sufficiently gross would qualify as reckless conduct and that representations and opinions... given without basis and in reckless disregard of their truth or falsity establish scienter under 10b-5. Rolf, 570 F.2d at 46 n.13, 48. In Novack v. Kasaks, 216 F.3d 300, 308 (2d Cir. 2000), the Second Circuit held that recklessness was 10

11 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 11 of 18 established where the defendant failed to review or check information that [he] had a duty to monitor, or ignored obvious signs of fraud. Id. at 308. See also Chill, 101 F.3d at (citing to various cases for the proposition that the standard of recklessness is high and holding that the supposed red flags set forth by the SEC did not amount to recklessness where defendant did not investigate record-high profits for evidence of fraud); Goldman v. McMahan, Brafman, Morgan & Co., 706 F. Supp. 256, 259 (S.D.N.Y. 1989) ( An egregious refusal to see the obvious, or to investigate the doubtful, may in some cases give rise to an inference of... recklessness. ); SEC v. Bremont, 954 F. Supp. 726, 730 (S.D.N.Y. 1997) (holding that recklessness would be established where defendant failed to make the slightest attempt to verify the fraudulent information). III. The Auditor Defendants The Auditor Defendants, although not in unison, raise three objections to the sufficiency of the Second Consolidated Complaint. First, Andersen and Mayer Rispler argue that the Complaint has failed to sufficiently allege any misstatement. In addition, all Auditor Defendants argue that Plaintiffs fail to allege that they acted with the requisite scienter. Finally, KPMG argues that Plaintiffs have failed to adequately allege loss causation. 11

12 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 12 of 18 A. Misstatements Andersen and Mayer Rispler 1 contend that the Second Consolidated Complaint must be dismissed for failure to plead with particularity their alleged misstatements. The Court agrees in part. There are two types of misstatements attributed to each auditor: (1) the audit was conducted in accordance with GAAS; and (2) Allou s financial statements render a fair depiction of the company. As to both Defendants, the Second Consolidated Complaint contains allegations indicating why both statements were false. First, the Second Consolidated Complaint alleges numerous GAAS violations by both Mayer Rispler and Andersen. (See generally, 2d Consol. Compl ; ) In addition, Plaintiffs allege that Allou s financial statements reflected overstated revenues, inventory, accounts receivable, net worth and earnings, and failed to disclose numerous related party transactions. But, as accurately pointed out by Mayer Rispler and Andersen, there is little specific indication of precisely how Allou s financial statements were impacted by the fraud during their respective audit periods. Most of Plaintiffs allegations are vague, spanning over a period of several years. Thus, it is 1 The Court notes that Plaintiffs have withdrawn all claims against Mayer Rispler concerning statements made in 1998 and

13 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 13 of 18 difficult to decipher whether Plaintiffs have adequately alleged material misstatements with respect to either Mayer Rispler or Andersen. While the Second Consolidated Complaint does indicate that specific amounts of Allou s receivables were overstated during the years 2000 and 2001, (2d Consol. Compl. 95, 120.), Plaintiffs fail to allege this fact had a material impact on Allou s financials. The PSLRA demands more precision than this. Accordingly, Plaintiffs claims with respect to Mayer Rispler and Andersen are DISMISSED. Plaintiffs, however are granted leave to file a Third Amended Complaint within thirty days of the date of this Order. B. Scienter The Court notes that, notwithstanding the Second Amended Complaint s lackluster allegations of misstatements, the Court finds that Plaintiffs have remedied their deficient allegations with respect to the Auditor Defendants scienter. Plaintiffs now allege several red flags and particularized departures from GAAS that, when coupled with evidence of the Individual Defendants large scale fraud, sufficiently allege facts permitting a strong inference that the Auditor Defendants recklessly conducted their audit. Specifically, the Second Consolidated Complaint contains particularized allegations concerning the Auditor Defendants: awareness and failure to adequately document and investigate 13

14 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 14 of 18 significant portions of unverified accounts receivables; material disparities in costing that went unreconciled; related party transactions that were not adequately investigated; and payments on invoices that did not match up to customers indicated on Allou s trading system. Under the circumstances, the Court finds sufficient allegations to support a finding of scienter. See In re WorldCom, Inc. Sec. Litig., No. 02-CV-3288, 2003 WL , *7 (S.D.N.Y. June 25, 2003) ( the allegations against Andersen adequately plead scienter. The Complaint alleges that Andersen had unlimited access to WorldCom s books and records and had, as WorldCom s independent auditor, an obligation to review and evaluate those records in order to form an opinion regarding WorldCom s financial statements... The allegations identifying the steps Andersen should have taken and failed to take, and the fraud it would have discovered if it had taken those steps, create a strong inference that Andersen acted recklessly in conducting the WorldCom audits (internal quotations, citations omitted)); In re Complete Mgmt. Inc. Sec. Litig., 153 F. Supp. 2d 314, 334 (S.D.N.Y. 2001) (recognizing that failure to adhere to GAAS may be one of several red flags that support an inference of scienter ). Accordingly, the Auditor Defendants motions to dismiss Plaintiffs 10b-5 claims for failure to allege scienter are DENIED. C. Loss Causation 14

15 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 15 of 18 It is settled that causation under federal securities laws is two-pronged: a plaintiff must allege both transaction causation, i.e., that but for the fraudulent statement or omission, the plaintiff would not have entered into the transaction; and loss causation, i.e., that the subject of the fraudulent statement or omission was the cause of the actual loss suffered. Suez Equity Inv., L.P. v. Toronto-Dominion Bank, 250 F.3d 87, *95 (2d Cir. 2001). Here, KPMG only objects to the sufficiency of Plaintiffs loss causation allegations. In Dura Pharmaceuticals, Inc. v. Broudo, the Supreme Court determined that, in securities fraud actions predicated on a fraud on the market theory, allegations that a plaintiff purchased a security at an artificially inflated price do not satisfy the requirements of loss causation. U.S., 125 S. Ct. 1627, 1631, (2005); See Emergent Capital Inv. Mmgmt., LLC v. Stonepath Group, Inc., 343 F.3d 189, (2d Cir. 2003). Rather, in assessing loss causation, a court must look further than allegedly artificially inflated purchase price and consider why the plaintiff lost the money on the purchase. See Emergent, 343 F.3d 198. KPMG argues that Plaintiffs have failed to adequately allege loss causation because the intervening events of the warehouse fire and the forced bankruptcy petition caused Allou s stock price to decline. In addition, KPMG contends that 15

16 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 16 of 18 Plaintiffs loss causation allegations are in insufficient because Plaintiffs fail to allege any correction to the 2002 financial statements or opinions. The Court finds neither argument compelling for two reasons. First, as a preliminary matter, the defense that intervening acts caused the Plaintiffs losses is an argument that is ill-suited for resolution on a motion to dismiss. Id. at 197. Second, according to Plaintiffs, the reason that each of the intervening events caused a downturn in Alou s stock price, was that the complained of fraud was actually revealed. Cf. id. at 199 (distinguishing cases where a plaintiff has adequately established loss causation from cases where the ultimate decline in the market price of a company's securities would be unrelated to that company s manager s concealed negative history. ) Accordingly, KPMG s motion to dismiss the Complaint for failure to allege loss causation is DENIED. IV. The Outside Director Defendants For the same reasons set forth in the Court s September Order, Plaintiffs claims against the Outside Director Defendants are DISMISSED. Contrary to Plaintiffs assertions, the Second Consolidated Complaint s new allegations concerning the adequacy of Allou s counsel s response to a document request for Board Minutes by the Bankruptcy Trustee have no bearing upon the fatal flaw set forth in the September Order: the Second Consolidated Complaint contains no allegations permitting a strong inference that the 16

17 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 17 of 18 Outside Directors were reckless, or otherwise should have uncovered the Individual Defendants fraud. Accordingly, Plaintiffs claims against the Outside Director Defendants are hereby DISMISSED WITH PREJUDICE. See In re WorldCom, Inc. Sec. Litig., No. 02-CV-3288, 2003 WL , at *6 (S.D.N.Y. Dec. 3, 2003). Plaintiffs have been given adequate opportunity to allege additional, specific facts indicating that the Outside Director Defendants acted with the requisite culpability to establish a 10b-5 claim and have set forth no indication of an ability to do so. 17

18 Case 2:03-cv JS -WDW Document 125 Filed 09/30/05 Page 18 of 18 CONCLUSION For the reasons explained above, Andersen s and Mayer Rispler s motions to dismiss are GRANTED in part and DENIED in part; KPMG s motion to dismiss is DENIED; and the Outside Director Defendants motion to dismiss is GRANTED. The dismissal as to the Outside Director Defendants is WITH PREJUDICE. The dismissal with respect to the Andersen and Mayer Rispler is WITHOUT PREJUDICE. Plaintiffs shall have thirty days from the date of this Order to file a Third Consolidated Amended Class Action Complaint. SO ORDERED Dated: Central Islip, New York September 30, 2005 /s/ JOANNA SEYBERT Joanna Seybert, U.S.D.J. 18