Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 1 of 14 UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK

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1 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 1 of 14 UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK HERBERT HANSON, Individually and On Behalf of All Others Similarly Situated, v. Plaintiff, Civil Action: 1:12-cv-3166 (JSR) FRAZER FROST, LLP, et al., Defendants TODD EDWARDS, Individually and On Behalf of All Others Similarly Situated, v. FRAZER, LLP, et al., Plaintiff, Defendants Civil Action: 1:12-cv (JSR) REPLY IN FURTHER SUPPORT OF DEFENDANT FRIEDMAN LLP S MOTION TO DISMISS THE AMENDED CONSOLIDATED CLASS ACTION COMPLAINT Andrew J. Morris (pro hac vice) MORVILLO LLP th Street NW, Suite 1006 Washington, DC (202) amorris@morvillolaw.com Richard J. Morvillo Suzanne K. Skinner MORVILLO LLP One World Financial Center 27th Floor New York, New York (212) rmorvillo@morvillolaw.com sskinner@morvillolaw.com Attorneys for defendant Friedman LLP

2 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 2 of 14 TABLE OF CONTENTS TABLE OF CONTENTS... i TABLE OF AUTHORITIES... ii I. It Is Well-Established That Lipsky v. Commonwealth United Corporation Prohibits Plaintiffs From Copying Unproven Allegations From Other Complaints... 1 II. Even Considering The Allegations Copied From The SEC Complaint, The Amended Complaint Fails To Plead Scienter or Falsity... 4 A. The Amended Complaint Does Not Plead Facts That Can Support A Strong Inference Of Scienter The Opposition confirms that Plaintiffs did not allege that the supposed red flags ever came to Friedman s attention Ji s statements were not red flags because they were lies told to hide any clue that the loans involved related parties... 6 B. The Amended Complaint Does Not Plead Facts Indicating That Friedman Believed Its Audit Opinion Was False... 9 CONCLUSION i

3 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 3 of 14 TABLE OF AUTHORITIES Cases Dexia SA/NV v. Deutsche Bank AG, 11 Civ. 5672, 2013 U.S. Dist. LEXIS 3482 (S.D.N.Y Jan. 4, 2013)... 2 In re Doral Financial Corporation Securities Litigation, 563 F. Supp. 2d 461 (S.D.N.Y. 2008)... 7 In re Health Mgmt. Inc. Sec. Litig., 970 F. Supp. 192 (E.D.N.Y 1997)... 7 In re Oxford Health Plans, Inc. Securities Litigation, 51 F. Supp. 2d 290 (S.D.N.Y 1999)... 9, 10 In re Phillip Service Corp., 383 F. Supp. 2d 463 (S.D.N.Y. 2004)... 7 In re Platinum & Palladium Commodities Litig., 828 F. Supp. 2d 588 (S.D.N.Y. 2011)... 2 Lipsky v. Commonwealth United Corp., 551 F.2d 887 (2d Cir. 1976)... 1, 3 RSM Prod. Corp. v. Fridman, 643 F. Supp. 2d 382 (S.D.N.Y. 2009), aff d, 387 F. App x 72 (2d. Cir. 2010)... 2 S. Cherry St., LLC v. Hennessee Grp. LLC, 573 F.3d 98 (2d Cir. 2009)... 9 SEC v. Citigroup Global Mkts., 827 F. Supp. 2d 328 (S.D.N.Y. 2011)... 2, 3 Whalen v. Hibernia Foods PLC,, 04 Civ. 3182, 2005 U.S. Dist. LEXIS (S.D.N.Y. Aug. 1, 2005)... 7 Rules Fed. R. Civ. P. 9(b)... 5 ii

4 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 4 of 14 In Friedman LLP s Memorandum in Support of its Motion to Dismiss the Amended Consolidated Complaint ( Mem. ), we explained why the allegations that Plaintiffs added in their Amended Complaint still do not enable them to state a claim for securities fraud. Plaintiffs Opposition ( Opp. ) does not resolve the deficiencies that we identified. First, we explained that the Court should disregard the new allegations because Lipsky v. Commonwealth United Corp., 551 F.2d 887, (2d Cir. 1976), prohibits Plaintiffs from copying unproven allegations made in an SEC complaint. Plaintiffs respond by contending that Lipsky prohibits the use of unproven allegations as evidence, but does not prohibit their use in pleadings. Yet Lipsky does apply to pleadings, as its plain language states and numerous Southern District of New York cases hold. Second, our opening Memorandum explained that, even if the Court considered the new allegations, the Amended Complaint still would fail to plead scienter or subjective falsity. The Opposition actually supports our argument that Plaintiffs cannot plead scienter based on a red flag theory: Plaintiffs concede that the Amended Complaint does not allege that the supposed red flags CEO Qinan Ji s statements to the directors ever came to Friedman s attention. Plaintiffs also fail to explain how Ji s statements can be considered red flags at all, since they were deceptive cover-ups of the truth, not red flag signals of it. Finally, the Opposition effectively confirms that the Amended Complaint does not plead subjective falsity. I. It Is Well-Established That Lipsky v. Commonwealth United Corporation Prohibits Plaintiffs From Copying Unproven Allegations From Other Complaints Friedman s opening Memorandum explained that Plaintiffs copied the Amended Complaint s allegations about Ji s statements from a complaint filed by the Securities and Exchange Commission, and that copying unproven allegations from an SEC complaint is prohibited by Lipsky, 551 F.2d at See Mem. 7. We also explained that the Amended

5 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 5 of 14 Complaint effectively distorts the SEC s complaint. The SEC made allegations against Ji and China Natural Gas. The SEC did not sue Friedman; to the contrary, the SEC alleged that Friedman was a victim actively misled by Ji and his accomplices. Mem. 8. Plaintiffs respond with two main arguments. They first (Opp. 32) purport to describe the relevant law in this Court, but they rely entirely on two decisions that constitute a distinctly minority position. 1 Frazer LLP already addressed these two cases in its Memorandum (at 7-8 n.4), and Friedman incorporated that discussion (Mem. 8). Similarly, another decision in this district explained that these two cases constitute a minority position. See RSM Prod. Corp. v. Fridman, 643 F. Supp. 2d 382, 403 (S.D.N.Y. 2009), aff d, 387 F. App x 72 (2d. Cir. 2010). (This Court relied on RSM s reading of Lipsky in Dexia SA/NV v. Deutsche Bank AG, 11 Civ. 5672, 2013 U.S. Dist. LEXIS 3482, *3 n.1 (S.D.N.Y Jan. 4, 2013).) In fact, cases in this district have repeatedly applied Lipsky to prohibit efforts by other plaintiffs to plead claims based on unproven SEC allegations. In re Platinum & Palladium Commodities Litig., 828 F. Supp. 2d 588, 593 (S.D.N.Y. 2011) (collecting cases). See also citations at Mem. 7-9; Frazer Mem. 8. Plaintiffs try to brush aside this entire line of cases as wrongly decided. Opp. 36. Plaintiffs specifically address three of the cases, but badly misread them as not meaning what they say which is that unproven allegations may [not] properly be cited in the pleadings in a parallel private action. SEC v. Citigroup Global Mkts., 827 F. Supp. 2d 328, 333 (S.D.N.Y. 2011). 2 1 In re Bear Stearns Mortg. Pass-Through Certificates Litig., 851 F. Supp. 2d 746, 768 n.24 (S.D.N.Y. 2012); SEC v. Lee, 720 F. Supp. 2d 305, 341 (S.D.N.Y. 2010). 2 Plaintiffs misconstrue this Court s decision in Dexia SA/NV, 2013 U.S. Dist. LEXIS 3482, at *24 as prohibiting the use of unproven allegations only if they are not directly related to the issues in the complaint that copies them. That opinion says no such thing, but states that the Court would strike * * * any paragraphs based on unproven allegations in unresolved cases. (emphasis added). Plaintiffs try to characterize this Court s decision in SEC v. Citigroup Global Markets, 827 F. Supp. 2d 328, as addressing only the use of SEC allegations as actual evidence 2

6 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 6 of 14 The second of Plaintiffs two arguments is that this Court should follow [c]ourts outside the Second Circuit. Opp. 32. The Opposition then cites three decisions from various district courts. None of these cases is relevant in light of the controlling authority in this Circuit. The Opposition tries to avoid that controlling authority Lipsky by arguing that the case prohibits the use of SEC allegations as actual evidence, but does not prohibit copying them into a pleading. Opp. 35. This argument is contradicted by Lipsky s plain language, which unmistakably addresses attempts to use SEC complaints in a new pleading. See discussion at Mem. 7-9; Frazer Mem. 7. Plaintiffs argument also is refuted by the overwhelming majority of decisions from this Court, as we explained above. Plaintiffs do find some language in Lipsky to their liking, quoting Lipsky s statement that courts should not strike portions of pleadings unless there is a strong reason for doing so. Opp. 30 (quoting Lipsky, 551 F.2d at 893). What Plaintiffs fail to note is that the Lipsky court did find a strong reason to strike part of a pleading, and that reason was the very same tactic Plaintiffs attempt in this case: copying unproven allegations from an SEC complaint. Lipsky 551 F.2d at This Court should follow Lipsky and disregard or strike the allegations about Ji s statements to directors. Once those allegations are omitted, the Amended Complaint contains no relevant allegations beyond those in the previous complaint, which the Court already dismissed. Opp. 37 n. 21. But, as noted in the above text, that case states that unproven allegations may [not] properly be cited in the pleadings in a parallel private action. 827 F. Supp. 2d at 333 (emphasis added). Plaintiffs also misread RSM Production Corp., and in any event ask this Court to reject it as wrongly decided. Opp

7 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 7 of 14 II. Even Considering The Allegations Copied From The SEC Complaint, The Amended Complaint Fails To Plead Scienter or Falsity A. The Amended Complaint Does Not Plead Facts That Can Support A Strong Inference Of Scienter In our opening Memorandum, we reviewed a series of deficiencies in Plaintiffs theory of scienter and explained why each deficiency is independently fatal to the Amended Complaint. Mem Plaintiffs Opposition makes two main responses. First, throughout their argument Plaintiffs fall back on assertions that Friedman was negligent: for example, Plaintiffs assert that the related party issue would have been detected by an audit performed in compliance with GAAS. Opp. 23. These would have assertions do nothing to plead a fraud claim because, as the Court explained when it dismissed the previous complaint, negligence is insufficient for a securities fraud claim. Op. 11 (citation omitted). Plaintiffs second response is to try to satisfy the test for a red flag theory of scienter, just as Plaintiffs tried to do with their previous complaint. But their Opposition fails to show that the Amended Complaint supports that theory. There are at least two independently fatal shortfalls. 3 The Opposition (at 28-30) also discusses China Natural Gas s financial statements for the first two quarters of 2011, which Friedman reviewed but on which it did not issue an opinion. It is not clear whether Plaintiffs (1) seek to hold Friedman responsible for these quarterly financial statements or (2) contend only that Friedman s conduct during these reviews supports Plaintiffs claim based on Friedman s opinion on the 2010 financial statements. In any event, the discussion does not help Plaintiffs. First, Friedman cannot be held liable where it made no public statement. See Mem. 23. And second, Plaintiffs allegations about Ji s statements in 2010 are irrelevant to Friedman s reviews of the first two quarters of 2011, because even Plaintiffs do not suggest that, when Friedman did its work on those quarters, it was required to review board minutes from earlier periods. 4

8 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 8 of The Opposition confirms that Plaintiffs did not allege that the supposed red flags ever came to Friedman s attention Plaintiff s red-flag theory fails at the outset because the Amended Complaint does not allege that the supposed red flag Ji s statements to the directors ever came to Friedman s attention. According to the Amended Complaint, Friedman could have learned about this information only if the information was in the board minutes, and the Opposition concedes that the Amended Complaint fails to allege that the board minutes contained this information. Because Plaintiffs did not allege this critical fact, they ask the Court to make an exception to the strict requirement that they plead facts to support their claim. See Mem (identifying the requirements of Fed. R. Civ. P. 9(b) and the PSLRA). Plaintiffs make the remarkable request that the Court assume that the minutes contained Ji s alleged statements. Plaintiffs contend that [t]here is a strong inference that discussion during Board minutes of material events such as possible FCPA investigations and special investigations * * * were memorialized in writings. Opp. 24. This argument is remarkable because this supposed strong inference was too weak to justify Plaintiffs relying on it to make the required allegation even on information and belief. Yet Plaintiffs ask the Court to rely on it to exempt the Plaintiffs from the requirement that they plead this critical fact. Plaintiffs provide no authority for this proposed exception to Rule 9 and the PSLRA. Moreover, the Amended Complaint itself should rule out this inference, which requires two distinct steps. The first step requires the Court to accept from the SEC s unproven allegations that Ji actually made the statements copied in Plaintiffs Amended Complaint. Even if the court permitted Plaintiffs to copy the SEC s complaint, this would provide a flimsy foundation for a multi-step factual inference. 5

9 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 9 of 14 The second step is to infer that company management put Ji s statements into board minutes, which it then showed to the auditors. This step rests on the assumption that the relevant personnel at China Natural Gas complied strictly with requirements of corporate regularity. Yet the basis of this entire case is that senior management violated the norms of corporate regularity, carrying out a sustained deception specifically relating to the Wang and Juntai loans. Surely the Court could not, to create an exception to the strict requirement that Plaintiffs plead facts, assume that China Natural Gas management acted properly in creating corporate documents relating to the loans, and in showing those documents to the auditors. 2. Ji s statements were not red flags because they were lies told to hide any clue that the loans involved related parties The red-flag theory fails at the next step as well, because Ji s misleading statements simply were not red flags not even faint ones. While plaintiffs have made a creative attempt to take a cover-up statement and recast it as a red flag, their effort is contrary to every known redflag case. As we explained in Friedman s memorandum (at 18-20), Ji s statements were falsehoods told precisely to lead listeners away from any suspicion that the loans involved related parties. These lies were the opposite of red flags; they were statements designed to hide the fact that the loans involved related parties. See Mem And the lies were effective, as confirmed by the fact that the directors and investors who heard them did not think the statements suggested the loans involved related parties. (As we explained, information is not a red flag when other parties also saw it and did not perceive it as a red flag. Mem. 19.) The Opposition does not dispute any of this. The Plaintiffs fall-back argument is that, even though Ji s statements seemed to rule out the possibility that the loans involved related parties, the statements still should be considered 6

10 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 10 of 14 red flags because they suggested that something about the loans was not right. Opp That argument fails for several reasons. To begin, Ji s statements contain nothing remotely like the common-sense indications of specific accounting problems found in the red-flag cases. Our opening Memorandum illustrated the nature of actual red flags by reviewing some of the leading cases. Mem (discussing In re Phillip Service Corp., 383 F. Supp. 2d 463, 475 (S.D.N.Y. 2004), In re Health Mgmt. Inc. Sec. Litig., 970 F. Supp. 192, (E.D.N.Y 1997), and Whalen v. Hibernia Foods PLC,, 04 Civ. 3182, 2005 U.S. Dist. LEXIS 15489, *10-*13 (S.D.N.Y. Aug. 1, 2005)). Plaintiffs Opposition does not dispute any of our descriptions. It does quote a few factfree conclusions from red-flag cases (Opp ), but those conclusory snippets do nothing to show that the allegations of the Amended Complaint identify even one red flag. The Opposition identifies no case that finds scienter based on one or two signs that, in hindsight, arguably indicate that something might be up. And no case even considers finding scienter where the evidence at issue (here, Ji s statements) covers up the problem that later triggers the lawsuit (here, related-party loans). Moreover, Ji s statements pointed toward a different and specific concern the FCPA issue and the company was addressing that concern through an investigation. Mem. 5. The Plaintiffs provide no reason whatsoever for an auditor to have nonetheless dug into the loans to see if they involved a different problem. In this vein, Friedman s Memorandum explained that this case is much like In re Doral Financial Corporation Securities Litigation, 563 F. Supp. 2d 461 (S.D.N.Y. 2008), where a few executives misled the rest of management and the auditor about certain side agreements, and the court concluded that the appropriate inference was that the executives had misled the auditors, 7

11 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 11 of 14 not that the auditors joined in the fraud. Mem. 14 (discussing Doral). Plaintiffs Opposition tries to distinguish Doral (Mem. 9 n. 7) by contending that the Amended Complaint in our case does not contain allegations that management actively misled the auditors. The Opposition badly misreads its own complaint and the other materials available on the defendants motions because, as we explained in our Memorandum (at 13-14), the Amended Complaint and the SEC complaint rely on allegations that senior management quite actively misled the auditors, as well as other executives and the board of directors. In fact, Ji s statements were just one piece in a larger pattern of management lies about the loans. Friedman s Memorandum (at 13-14) noted the series of misrepresentations and fraudulent acts by CEO Ji and his accomplices, including the company s Chief of Internal Audit. It would be contrary to law to conclude that, because a successor auditor did not see through management deception that also misled company executives, company directors, and the predecessor auditor, the successor auditor deliberately assisted the wrongdoers in perpetrating the fraud. See Mem In sum, the Opposition confirms that the allegations of the Amended Complaint do not support the required compelling inference of scienter. At each step in its scienter theory, the Opposition asks the Court to give Plaintiffs a pass on the governing legal requirements: On the Lipsky principle that prohibits plaintiffs from basing a claim on unproven allegation in an SEC complaint. (Not only do Plaintiffs seek relief from this rule, they seek to base a claim against Friedman on allegations against parties other than Friedman, where the SEC alleged that those parties actively misled Friedman.) On the principle that, where management actively misled the auditor and others, it is especially difficult to infer that the auditor intended to commit fraud. See Mem (Plaintiffs Opposition ignores this problem.) On the requirement that Plaintiffs allege facts indicating that Friedman actually saw the alleged red flag. (Plaintiffs concede that the Amended Complaint does not allege that the minutes contained Ji s statements. They ask the Court to fill in this fact for them, using 8

12 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 12 of 14 the SEC S unproven allegations combined with an inference that is unsupported by any authority.) On the requirement that a red flag case involve information that actually suggests a fraud, and multiple instances of such red flag information. (Ji s statements were not signal flags, they were cover-ups. And they were an apparent confession of a possible FCPA problem, which the company then investigated.) Because Plaintiffs theory fails at every one of these steps, their Amended Complaint does not begin to support the required compelling inference that Friedman acted with a state of mind that approximate[d] an actual intent to aid in the fraud being perpetrated by [management]. S. Cherry St., LLC v. Hennessee Grp. LLC, 573 F.3d 98, 110 (2d Cir. 2009). See Mem (describing the standard for pleading scienter in 10b cases). B. The Amended Complaint Does Not Plead Facts Indicating That Friedman Believed Its Audit Opinion Was False Friedman s Memorandum explained (at 22-23) why the Amended Complaint fails to plead, as it must to state a claim, that Friedman believed its audit opinion was false. Plaintiffs response is half-hearted at best. The Opposition s primary response is that the Amended Complaint pleads a misstatement because it pleads scienter. Opp. 26. But as our Memorandum explained, and as we review above, the Amended Complaint does not plead scienter. So the Amended Complaint fails to plead subjective falsity as well. The Opposition goes on to review Plaintiffs allegations that various China Natural Gas financial statements were not fairly stated (Opp ), but that review does nothing to establish that the auditor believed its audit opinion was false. The Opposition finishes its falsity argument with a parenthetical reference to In re Oxford Health Plans, Inc. Securities Litigation, 51 F. Supp. 2d 290, 294 (S.D.N.Y 1999), noting that the plaintiff in that case successfully pleaded scienter by an auditor even though the case did not involve a restatement. It is not apparent why Plaintiffs cite this case, since it only highlights the stark difference between Plaintiffs Amended 9

13 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 13 of 14 Complaint and a case that involves actual red flags. Oxford Health involved numerous strong signs of material accounting problems that went to the heart of the company s financial statements, and that were known to the auditor. Id. at 295. These signs included the inability of the company s computer accounting system to track basic information including accounts receivable and accounts payable; a large fine by state regulators; a regulator demand that the company fire the CFO; and known accounting misstatements in the hundreds of millions of dollars. Id. Even then, the Oxford Health court was careful to note the cumulative effect of these numerous red flags, concluding that taken together, they supported an inference of scienter. Id. Nothing in our case remotely approaches these allegations. CONCLUSION For the reasons set forth above and in Friedman s opening Memorandum, the Amended Consolidated Class Action Complaint should be dismissed with prejudice. Dated: November 26, 2013 Respectfully submitted, /s/ Andrew J. Morris Richard J. Morvillo Suzanne K. Skinner MORVILLO LLP One World Financial Center 27th Floor New York, New York (212) rmorvillo@morvillolaw.com sskinner@morvillolaw.com Andrew J. Morris (pro hac vice) MORVILLO LLP th Street NW, Suite 1006 Washington, DC (202) amorris@morvillolaw.com Attorneys for defendant Friedman LLP 10

14 Case 1:12-cv JSR Document 34 Filed 11/26/13 Page 14 of 14 CERTIFICATE OF SERVICE I certify that on November 26, 2012, I electronically filed the foregoing document with the Clerk of the Court using CM/ECF which will send notification of such filing to the following registered participants: Thomas J. McKenna Gainey & McKenna, LLP 440 Park Ave., South 5th Floor New York, NY Attorney for plaintiff Larry Weiser Gregory Egleston Egleston Law Firm 440 Park Ave., South 5th Floor New York, NY Attorney for plaintiff Larry Weiser Lawrence A. Steckman Eaton & Van Winkle LLP 3 Park Ave., 16th Floor New York, NY Attorneys for defendant Frazer, LLP Frederick T. Isquith, Sr. Gregory M. Nespole Martin E. Restituyo Wolf Haldenstein Adler Freeman & Herz LLP 270 Madison Ave. New York, NY Attorneys for plaintiff Todd Edwards /s/ Andrew J. Morris Andrew J. Morris