Plaintiff’s Response to PWC’s Motion for Summary Judgment

Harward v. PriceWaterhouseCoopers

Description: This case was a securities fraud case brought by plaintiffs against international accounting firm PriceWaterhouseCoopers (“PWC”).  Plaintiffs relied upon financial statements audited by PWC in deciding to merge their company with another company and accept $43 million worth of the other company’s shares of stock as the sale price for the acquisition.  After the transaction closed, various misrepresentations in the acquiring company’s financial statements came to light that caused the stick to plummet in value and the company to eventually be de-listed.  PWC filed a summary judgment motion arguing that it owed no duty to third parties such as plaintiffs because they were not with the “limited group” of persons entitled to rely on PWC’s work.   Defendants also argued that any reliance by plaintiffs on the acquiring company’s financial statements was not reasonable. This brief was filed by Heygood, Orr & Pearson on behalf of their client.

No. 02-9881
MARK HARWARD, ANGELA HARWARD,
BRENDA STONER, THOMAS STONER,
MERRILL WERTHEIMER, SS MAHANT-
SHETTI, HOWARD TIGELAAR, CATHY
TIGELAAR, KENNETH SCHIBLER,
MARY SCHIBLER, SCOTT LANE,
CANDACE LANE, and HARWARD
CHILDREN’S 1999 TRUST,

Plaintiffs,

v.

PRICEWATERHOUSECOOPERS L.L.P. and
UBS WARBURG L.L.C.,

Defendants.

IN THE DISTRICT COURT OF
DALLAS COUNTY, TEXAS
44TH JUDICIAL DISTRICT

PLAINTIFFS’ RESPONSE TO PWC’S MOTION FOR SUMMARY JUDGMENT

Plaintiffs file this Response to the Motion of Defendant PricewaterhouseCoopers L.L.P. for Summary Judgment (the “Motion”), and would respectfully show the Court as follows:

INTRODUCTION

Defendant PricewaterhouseCoopers L.L.P. (“PWC”) is an international accounting and consulting firm.  PWC was the auditor for HPL Technologies, Inc. (“HPL”), a provider of yield optimization software formed in 1989.  Plaintiffs are former shareholders of Texas corporation Covalar Technologies Group Inc. and its wholly-owned subsidiary, TestChip Technologies, Inc. (collectively referred to as “CTG”).  Plaintiffs relied on HPL’s Prospectus which had been issued as part of HPL’s IPO and the financial statements included in the IPO Registration Statement, which had been audited by PWC, in deciding to sell their shares in CTG for shares in HPL in a February 2002 merger transaction.  Well after the merger was complete, Plaintiffs learned that the financial statements of HPL upon which they relied were filled with numerous inaccuracies and misrepresentations and had not been prepared in accordance with GAAS and GAAP as PWC had warranted.  As a result of these misrepresentations and their ultimate public disclosure in July 2002, the price of HPL stock plummeted from $14.10 per share on July 18, 2002 to as low as $4.00 per share on July 19, 2002 before trading was halted.  Trading never reopened on the NASDAQ, which recently de-listed HPL.  Shares in HPL have recently traded over the counter at less than 22 cents per share.  Plaintiffs’ shares in HPL, which had been valued at approximately $33,000,000 at the time of the merger, have been revealed to be essentially worthless.  As set forth more fully below, PWC is liable for the losses experienced by Plaintiffs as a result of its false and misleading audit opinions upon which Plaintiffs justifiably relied.

BACKGROUND FACTS

I.          HPL goes public with financials audited by PWC and a Prospectus approved of and distributed by UBS.

 

HPL is a provider of yield optimization software solutions for semiconductor companies.  This lawsuit arises out of the gross misstatements of HPL’s financial condition in publicly-filed financial statements and other documents.  These misstatements pervaded HPL’s Prospectus and other publicly-filed documents prepared in connection with its initial public offering of equity securities (“IPO”) in July 2001.

PWC served as the independent auditor of HPL’s financial statements that were included in HPL’s IPO prospectus.  PWC included its report in the IPO prospectus stating that, among other things, HPL’s financial statements were audited in accordance with generally accepted auditing standards (“GAAS”) and were in conformity with generally accepted accounting principals (“GAAP”).

UBS served as the lead underwriter for HPL’s IPO and was involved in the negotiations of the Merger.  UBS made explicit and implicit representations that it had investigated the business and financial condition of HPL, and made explicit and implicit favorable recommendations of HPL’s stock to the public and to the Plaintiffs.

HPL had previously attempted an initial public offering of HPL in 2000.  At that time, the lead underwriter was Donaldson, Lufkin & Jenrette (“DLJ”), including two investment bankers, Shannon Soqui and Phokion Potamianos.  PWC was HPL’s outside auditor at the time of the IPO.  After the startling discovery that one of HPL’s officers had been the subject of felony criminal action involving a former employer and due to problems with HPL’s revenue, that IPO was aborted.  PWC and UBS both had full and complete knowledge of the aborted IPO.  Following the aborted IPO, Soqui and Potamianos left DLJ and joined UBS in or about November 2000.  By February 2001, UBS, led by Soqui and Potamianos, pitched a new IPO to HPL.

During the period that UBS acted as lead underwriter in HPL’s initial public offering, UBS provided coverage of HPL’s stock and assisted in the merger between HPL and CTG.  UBS research analysts, including Byron Walker and Zack Galler,  issued a series of glowing reports about HPL’s stock.  In the analyst reports, UBS made misrepresentations regarding HPL.  For example, in the August 28, 2001 report, UBS stated that HPL followed conservative revenue recognition policies.  Likewise, UBS falsely stated that there were no credit risks with respect to HPL’s outstanding balances in its reports.

UBS Paine Webber, a related UBS entity, made a multi-million dollar loan to David Lepejian in October 2001 outside UBS’ standard lending parameters that eventually made its way into the accounts of HPL under the guise of customer payments.  Because HPL stock collateralized this loan, UBS had a direct financial interest in maintaining the market price of HPL stock.

II.        HPL acquires CTG in a $43 million cash and stock merger.

On January 29, 2002, HPL entered into an agreement to acquire all outstanding shares and options of CTG for $10 million in cash and up to 2.5 million shares of HPL common stock, for a total purchase price of approximately $43 million.  Plaintiffs were shareholders of CTG at the time, and Plaintiffs Mark Harward, Brenda Stoner and Merrill Wertheimer were involved in the negotiations with HPL over the purchase of CTG.  Between them, at the time of the Merger, Plaintiffs owned or controlled approximately 93% of the stock of CTG.  Plaintiff Harward was CTG’s President and Chief Executive Officer and signed the Agreement and Plan of Merger (the “Merger Agreement”) as the representative of the shareholders of CTG.

In entering into the Merger Agreement, Plaintiffs relied on HPL’s Prospectus which had been issued as part of HPL’s IPO and the financial statements included in the IPO Registration Statement, which had been audited by PWC.  Plaintiffs also reviewed and relied upon analyst reports of HPL stock published by UBS.  HPL was represented in the negotiations to acquire CTG by UBS, and UBS representatives met with Plaintiffs in December 2001 to discuss and negotiate the merger.

III.       Disclosure of the misrepresentations in HPL’s financial statements causes HPL stock to drop like a rock.

On July 19, 2002, HPL stunned the marketplace when it issued a press release announcing that it had initiated an investigation into financial and accounting irregularities involving revenue reported during prior periods.  HPL reported that a material amount of revenue was improperly recognized during one or more earlier periods.  As a result of the HPL press release, HPL’s shares fell as much as 72% before NASDAQ regulators halted the trading.  HPL stock, which had closed at $14.10 per share on July 18, 2002, dropped to as low as $4.00 per share on July 19, 2002 before trading was halted.  Trading never reopened on the NASDAQ, which de-listed HPL.  Shares in HPL have recently traded over the counter at approximately 22 cents per share.  Plaintiffs’ shares in HPL, which had been valued at approximately $33,000,000 at the time of the merger, are essentially worthless.  Ultimately, HPL amended its 10-K in November 2002 in a reaudit conducted by PWC and materially reduced its revenue for the 2002 fiscal year by $9.1 million, or 68%, to $4.3 million.

ARGUMENT AND AUTHORITIES

I.          The Motion should be denied as to Plaintiffs’ claims for negligent misrepresentation.

A.        Plaintiffs are clearly within the limited group of persons to whom PWC owed a duty of care in auditing HPL’s financial statements.

 

For decades, Texas courts have recognized that accountants and auditors such as PWC are liable for negligent misrepresentations relied upon by third parties.  As the Fort Worth Court of Appeals said more than thirty years ago:

An accountant may be held liable to third parties who rely upon financial statements, audits, etc., prepared by the accountant in cases where the latter fails to exercise ordinary care in the preparation of such statements, audits, etc., and the third party because of such reliance suffers financial loss or damage.

Shatterproof Glass Corp. v. James, 466 S.W.2d 873, 880 (Tex. Civ. App. – Ft. Worth 1971, writ ref’d n.r.e.).  According to the Restatement (Second) of Torts §552, which has been expressly adopted by Texas courts, such liability extends to “a person or one of a limited group of persons for whose benefit and guidance [the defendant] intends to supply the information or knows that the recipient intends to supply it.”  Restatement (Second) of Torts §552(2)(a) (1977).  Because Plaintiffs clearly fall within this limited group, PWC’s Motion for Summary Judgment on Plaintiffs’ claims for negligent misrepresentation should be denied.

1.         PWC need not have been aware of the individual Plaintiffs.

In its Motion, PWC asserts that Plaintiffs cannot be within the limited group of persons entitled to bring a claim for negligent misrepresentation unless PWC was specifically aware of the individual Plaintiffs as well as the fact that they would rely upon PWC’s audited financials of HPL.  Motion at pp. 7-8.  This assertion is a misstatement of Texas law and the Restatement of Torts.  As set forth above, the Restatement extends liability to “the person or one of a limited group of persons” to whom the Defendant intends to supply the information or knows that the recipient intends to supply it.  Restatement (Second) of Torts §552(2)(a) (1977).  Comment h of the Restatement specifically rejects the notion that the Defendant must know of the specific identity of the eventual plaintiff, stating that “it is not necessary that the maker should have any particular person in mind as the intended, or even the probable, recipient of the information.”  Restatement (Second) of Torts §552, comment h (1977). The Restatement explains that “it is sufficient, in other words, insofar as the plaintiff’s identity is concerned, that the maker supplies the information for repetition to a certain group or class of persons and that the plaintiff proves to be one of them, even though the maker never had heard of him by name when the information was given.”  Id.

Courts applying Texas law have reached this same conclusion.  For example, the United States District Court for the Southern District of Texas recently stated as follows:

Under [Section 552], as in the case of a fraudulent misrepresentation (see §531), it is not necessary that the maker should have any particular person in mind as the intended, or even the probable, recipient of the information.  In other words, it is not required that the person who is to become the plaintiff be identified or known to the defendant as an individual when the information is supplied.

In re Enron Corp. Sec. Derivative and ERISA Litig., 235 F. Supp. 2d 549, 608 (S.D. Tex. 2002).  The Dallas Court of Appeals similarly rejected as “too artificial a distinction” any attempt to construe Section 552 so as to “limit the class of third parties who may recover to those actually and specifically known by the defendant.”  Blue Bell, Inc. v. Peat Marwick Mitchell & Co., 715 S.W.2d 408, 412 (Tex. App. – Dallas 1986, writ ref’d n.r.e.).  PWC’s attempt to limit negligent misrepresentation claims to those specific individuals or entities known by a defendant at the time of the misrepresentation seeks to distort Texas law and the Restatement of Torts on which it is based.

2.         Plaintiffs need only show that PWC knew or should have known that a limited group of which Plaintiffs are members would receive the audited financials.

 

In order to be within the group of persons entitled to bring a negligent misrepresentation claim against PWC, Plaintiffs need only show that PWC knew or should have known that a group of which they are members would receive the audited financials.  See, e.g., Blue Bell, 715 S.W.2d at 412 (“We hold that if, under current business practices and the circumstances of that case, an accountant preparing audited financial statement knows or should know that such statements will be relied upon by a limited class of persons, the accountant may be liable for injuries to members of that class relying on his certification of the audited reports.”); see also Cook Consultants, Inc. v. Larson, 700 S.W.2d 231, 234 (Tex. App. – Dallas 1985, writ ref’d n.r.e.) (“The conflicting policies are best harmonized by limiting liability to the person or class of persons whom the maker of the representation intends to benefit or who foreseeably may be expected to rely on the information.”).

In extending liability to the limited group of persons about which a defendant knew or should have known, the Dallas Court of Appeals was clearly “adopt[ing] a less restrictive interpretation of Section 552 than would be indicated by the comments thereunder ….”  Blue Bell, 715 S.W.2d at 412. Other courts applying Texas law have recognized that the interpretation of Section 552 by Texas courts is broader than that advocated by courts in other states.  See, e.g., Steiner v. Southmark Corp., 734 F. Supp. 369, 280 n.10 (N.D. Tex. 1990) (“The court does not consider the Fifth Circuit’s decision in Geosearch to be inconsistent with recent Texas precedent.  To the extent Geosearch can be read to reach a different result, however, it is clear that Texas courts now construe Section 552 more broadly than at the time Geosearch was decided.”).  In fact, the Fifth Circuit recognized in Scottish Heritable Trust, PLC v. Peat Marwick Main & Co., 81 F.3d 606, 614 (5th Cir. 1996), cert. denied, 519 U.S. 869 (1996) that “in Blue Bell, the Court held that actual knowledge of a particular plaintiff or class of plaintiffs is not necessary if the defendant should have had this knowledge.  To this extent, Texas law is indeed less restrictive than the Restatement.”

In its Motion, PWC challenges well-established Texas law by arguing that the “should have known” standard espoused by Blue Bell, Cook, and other cases was impliedly overruled by the Texas Supreme Court in McCamish, Martin, Brown & Loefler v. F.E. Appling Interests, 991 S.W.2d 787 (Tex. 1999).  In support of this proposition, PWC cites the slip copy decision in Compass Bank v. King Griffin & Adamson, P.C.,No. Civ. A. 3:01-CV-2028-N,  2003 WL 22077721 (N.D. Tex. Sept. 5, 2003).  In that case, the Northern District of Texas held that “the Texas Supreme Court in McCamish overruled by implication a portion of the Blue Bell opinion extending accountant liability to those parties the accountants should know would rely on their opinions.” Id. at *4.

There are a number of problems with the Northern District’s interpretation of McCamish as somehow overruling by implication Blue Bell, Cook and their progeny.  First, if the Texas Supreme Court had wanted to overrule Blue Bell, it clearly could have done so in its written opinion in McCamish but did not.  Moreover, in citing Blue Bell with approval in a string cite, the Texas Supreme Court stated that “Courts applying Texas law have recognized a Section 552 cause of action against other professionals as well.”  McCamish, 991 S.W.2d at 791.  Through this statement, the Texas Supreme Court clearly stated that Blue Bell applied Texas law rather than a distortion of Texas law as the Northern District held in Compass Bank.  And the Texas Supreme Court in Ernst & Young, L.L.P. v. Pacific Mutual Life Ins. Co., 51 S.W.3d 573, 580 (Tex. 2001) also cited Blue Bell with approval.

Moreover, to the extent the Supreme Court in McCamish made statements regarding the reach of Section 552, they were clearly dicta, as the Court stated that it was being presented with “one precise question:  whether the absence of an attorney-client relationship precludes a third party from suing an attorney for negligent misrepresentation under the Restatement (Second) of Torts §552” and went on to state that “we do not decide or address in any way the liability of McCamish, Martin in this case.”  Id. at 791.  Because of the limited scope of its inquiry, any statements made by the Court regarding the scope of Section 552 are clearly dicta.

As set forth above, the courts in Steiner and Scottish Heritable clearly recognized that Blue Bell’s interpretation of Section 552 was broad.  Should the Texas Supreme Court have wanted to narrow this interpretation, it clearly could have done so in McCamish.  The fact that it did not completely contradicts the notion that the court in McCamish somehow impliedly overruled Blue Bell’s interpretation of the Restatement.  For this reason, to show that they have standing to pursue their claims for negligent misrepresentation, Plaintiffs need only show that PWC knew or should have known that a limited group of which Plaintiffs are members would receive the audited financials of HPL which it prepared.

3.         Plaintiffs are within the limited group under the facts here.

a.         PWC knew HPL intended to pursue acquisitions with the funds raised through the IPO.

 

Regardless of whether this Court applies the “should have known” standard set forth in Blue Bell or the more restrictive interpretation of Section 552 advocated by the Northern District of Texas in Compass Bank, Plaintiffs are clearly within the limited group under the facts of the instant case.  Simply put, the facts demonstrate that PWC knew that HPL intended to supply the audited financials to a limited group of persons including Plaintiffs herein as shareholders of acquisition target CTG.  First, the IPO Prospectus into which the PWC-audited financials were incorporated clearly stated that HPL intended on pursuing strategic acquisitions.  For example, on page 2 of the Prospectus, HPL described part of its core strategy as pursuing strategic alliances and acquisitions, stating that “we continually pursue opportunities to enhance our ability to build our customer base, add technical expertise and leverage our existing yield-optimization software solutions.” See Exhibit A at p. 2.  When describing the company, HPL explained that its holding company structure “was selected as the more efficient method to accomplish the change in domicile [from California to Delaware] and to create flexibility for future acquisitions and financing.”  Id. HPL also stated that “we may attempt to acquire additional businesses or technologies that we believe fit strategically with our businesses.”  Id. at 10.

Despite these numerous statements in the Prospectus that HPL intended to pursue acquisitions, PWC argues in its Motion that the Prospectus expressly stated that HPL management was not currently engaged in negotiations with respect to any acquisitions.  Motion at p. 9.  Not only is the truth of this statement belied by the other predictive statements mentioned above, but it is patently false as well.  Specifically, Doug Brown, one of the lead auditors for PWC on the HPL audit project, stated in his deposition that he was aware at the time the Prospectus was issued in June 2001 that HPL was contemplating acquiring a company called Fabcentric.  See Deposition of Doug Brown attached hereto as Exhibit B (“Brown Depo”) at p. 328.  In fact, an internal PWC document for the period ending March 2001, prior to the issuance of the Prospectus, stated that “PWC will be performing audit of the acquisition company Fabcentric.”  See Brown Depo at p. 329; Brown Depo Exh. 116 attached hereto as Exhibit C.

Not only was PWC specifically aware of the ongoing discussions with Fabcentric regarding its potential acquisition, but it also knew that other potential acquisition targets would likely review the IPO Prospectus and financials contained therein.  For example, Doug Brown testified as follows:

Q.        And PwC knew that the audited financials of HPL that it was auditing would be included in the prospectus for that IPO; correct?

A.        Correct.

Q.        And PwC knew that its investors would likely rely on those audited financials in making investments decisions; isn’t that correct?

MR FINK:  Objection, form.

THE WITNESS:  Yes, they could.

BY MR PEARSON:

Q.        And PwC knew that HPL — one of the reasons for HPL’s IPO was to acquire other companies; correct?

A.        I believe that’s — they have stated that in the prospectus, yes.

Brown Depo at p. 326.  Brown also testified regarding a PWC document indicating that HPL was in an acquisition phase prior to the time of the IPO:

Q.        And if you turn to the next page 87748, sort of in the middle of the page it says, “HPL is in an acquisition phase”; do you see that?

A.         Yes, I do.  Yes I do.

Q.         Is that something that you understood in 2001?

A.        Yes.

Q.        And did you understand that one of the purposes of the IPO that was going to occur in 2001 was to raise money for future acquisitions?

A.        I believe that may have been one of the items they included in their S-1.

Brown Depo at p. 51; Brown Depo Exhibit 101 attached hereto as Exhibit D.  Such evidence shows that PWC knew or should have known that potential investors like Plaintiffs would receive and rely on its audit opinions.  See, e.g., Anixter v. Home-Stake Production Co., 77 F.3d 1215, 1227 (10th Cir. 1996) (jury could have concluded that auditor “knew or should have known that his representations would reach potential investors and they would reasonably rely on them” when evidence showed that auditor certified financial statements of corporation and that its audit opinions were reproduced in prospectuses).

In Simpson v. Specialty Retail Concepts, Inc., 908 F.Supp. 323 (M.D. N.C. 1995), investors in a company called Specialty Retail Concepts (“SRC”) brought suit against accounting firm Deloitte, Haskins and Sells (“DH&S”) based on its faulty 1986 audit opinion.  DH&S moved for summary judgment on the plaintiffs’ negligent misrepresentation claims, alleging that public-market investors could not be within the “limited group” to which DH&S intended to supply its audit opinion or knew that SRC intended to supply it.  The court disagreed, stating as follows:

While public-market investors who read and rely on 10-K filings and annual reports likely constitute a large group, whose members were not individually designated in advance, it is an identifiable group “for whose benefit [DH&S] intends to supply the information or knows that [SRC] intends to supply it”.  DH&S’s attempt to read some further independent meaning into the phrase “limited group” is unwarranted.

Id. at 331.

Similarly, in Guenther v. Cooper Life Sciences, Inc., 759 F. Supp. 1437 (N.D. Calif. 1990), a group of investors who purchased stock in Cooper Life Sciences brought a class action against Peat Marwick based on misleading audit reports it had issued.  Peat Marwick moved for summary judgment based on plaintiffs’ claim for negligent misrepresentation under Section 552 of the Restatement (Second) of Torts, arguing that “[i]nvestors are members of a potentially unlimited class and therefore do not fall within the ambit of Section 552.”  Id. at 1443.  The Court rejected this argument, holding that potential investors could fall within the limited group:

Peat Marwick’s contention that potential investors constitute an unlimited class presupposes that the reference to “limited” in section 552 refers to a group’s size.  The adjective “limited,” however, pertains not to size, but to identifiability.  While size is certainly one of the criteria that may be used to limit a group’s membership, it is but one of many possible restrictive criteria that can define the contours of a “limited group.”  Thus, it is not necessary that a group be restricted by size in order to qualify as “limited” under section 552. It is enough that providers of information know that their client intends to provide the information for the benefit and guidance of a group of people, and that the information provider understand the parameters that define the third-party group.  Where a group is identifiable, accountants and other information providers are not relieved of liability merely because the group of people whom they intend to influence with their information is too large.

Here, Peat Marwick was aware not just of “the ever-present possibility of repetition to anyone,” but of CLS’s intention to distribute the audited report to a clearly defined group – potential investors.  As members of that limited group, plaintiffs were owed a duty by Peat Marwick.

Id.; see also Scottish Heritable Trust, PLC, 81 F.3d at 614 (“We do not suggest that a potential purchaser can never be a member of a ‘limited group’” entitled to bring a claim for negligent misrepresentation).

b.         PWC knew that HPL was planning to acquire CTG.

In addition to PWC’s knowledge of the pending Fabcentric acquisition and its knowledge of other potential acquisitions, PWC learned shortly after the Prospectus was issued that HPL was contemplating acquiring CTG in particular.  In his deposition, Michael Scarpelli, the PWC partner in charge of the HPL audit, testified that in December 2001, HPL’s CEO, David Lepejian, “kind of laid out for me what – where the company he thought was going, laid out a number of acquisitions he planned on doing; one of them was Covalar.”  Deposition of Michael Scarpelli attached hereto as Exhibit E (“Scarpelli Depo”) at p. 115.  Scarpelli also testified that in Fall 2001 he told Lepejian that he would need to bring additional personnel into HPL if he was going to be pursuing the acquisitions they had discussed.  Id. at pp. 120-121.  Finally, Scarpelli admitted that, prior to the IPO, he was aware that Lepejian was interested in acquiring other companies and that the $70 million that HPL was going to derive from the IPO was largely intended to be used for acquisitions.  Id. at pp. 129-130.   Given these uncontroverted facts, it is clear that Plaintiffs are within the group of persons PWC knew or should have known would receive the audited financials from HPL.   See, e.g., Ernst & Young, 51 S.W.3d at 581 (“General industry practice or knowledge may establish a basis for foreseeability for negligence. . . .”).

In Bowers v. Allied Investment Corp., 822 F. Supp. 835, 840 (D. Maine 1993), Peat Marwick was sued for negligent misrepresentation regarding its audit of CAR’s financial statements. Peat Marwick argued that Allied could not be within the limited group of persons under Section 552 because there was no evidence that Peat Marwick was aware of Allied at the time the audit was performed.  The federal district court rejected this analysis, noting that Peat Marwick became aware of Allied’s reliance on the audited financials after they were issued but before Allied actually relied upon them.  The Court held that such knowledge on behalf of Peat Marwick led Allied to fall within the group of persons entitled to the protection of Section 552, stating as follows:

If, as Allied asserts, Peat Marwick had actual knowledge that Allied would rely on the information provided to CAR and did nothing to prevent such reliance, a coloraable claim for negligent misrepresentation may lie because Peat Marwick may be found to have, in effect, consented to the use of the information after it was provided to CAR.  While the Restatement seeks to allow professionals to retain some control over their limited exposure at the time they actually perform their services, professionals cannot invoke the Restatement’s limitations and liability if they allow third parties to use their work after performing the actual service.

Id. Here, PWC knew about the specific potential acquisition of Fabcentric, knew that HPL was in an acquisition mode, knew that the proceeds from the IPO would likely be used to fund further acquisitions and, prior to the time of the merger, knew specifically that HPL intended to acquire CTG.  Under such circumstances, Plaintiffs clearly fall within the group of persons entitled to bring a claim for negligent misrepresentation.

4.         Because PWC was under a public duty to file the certified financials, Plaintiffs are assumed to be within the limited group.

 

Finally, Plaintiffs are within the limited group of persons entitled to bring a claim for negligent misrepresentation under Section 552 because PWC was under a “public duty” to provide HPL’s audited financials to the public through the IPO Prospectus filed with the SEC.  Section 552 of the Restatement specifically states as follows:

The liability of one who is under a public duty to give the information extends to loss suffered by any of the class of persons for whose benefit the duty is created, in any of the transactions in which it is intended to protect them.

Restatement (Second) of Torts §552(3)(1977).  It is unquestioned that the audited financials were required to be filed with the SEC as part of HPL’s IPO Prospectus.  It is also clear that public filing requirements are intended to protect investors in publicly traded companies, including those who invest through a merger or acquisition.  See, e.g., Ernst & Young, 51 S.W.3d at 582 (“the general purpose behind a statute requiring a corporation to publicly file its financial condition is to make the information available to all those who consider it important in determining their course of action in any type of transaction with the corporation in question.”).  As the U.S. Supreme Court has stated:

Corporate financial statements are one of the primary sources of information available to guide the decisions of the investing public.  In an effort to control the accuracy of the financial data available to investors in the securities markets, various provisions of the federal securities laws require publicly held corporations to file their financial statements with the Securities and Exchange Commission.  Commission regulations stipulate that these financial reports must be audited by an independent certified public accountant in accordance with generally accepted auditing standards.

United States v. Arthur Young & Co., 465 U.S. 805, 810-11 (1984); see also McGann v. Ernst & Young, 102 F.3d 390, 397 (9th Cir. 1996), cert. denied, 520 U.S. 481 (1997) (“Indeed, federal reporting requirements, such as the form 10-K, exist ‘to control the accuracy of the financial data available to investors in the securities markets.’”).

In Ernst & Young, the Texas Supreme Court addressed Section 552’s “public duty” presumption and whether it applied to plaintiffs suing Ernst & Young for issuing a false and misleading 1986 audit opinion of RepublicBank.  The plaintiffs in that case purchased notes of Interfirst issued in 1982 after learning in 1987 of Interfirst’s merger with RepublicBank and concluding that the merged bank could adequately back the notes.  Ernst & Young, 51 S.W.3d at 575-76.  The court  refused to apply Section 552’s public duty assumption regarding the filing of RepublicBank’s 1986 10-K to plaintiffs who never bought securities in either RepublicBank or the merged entity, but who merely bought notes Interfirst had issued five years earlier.  In reaching this conclusion, however, the court noted that Rule 552’s public duty presumption “might apply” to purchasers of securities in the merged entity who relied on the 1986 RepublicBank 10-K.  Such purchasers are clearly analogous to Plaintiffs herein, who bought shares in HPL in February 2002 in reliance on HPL’s 2001 audited financial statements filed with the SEC as part of its IPO prospectus.[1] For this additional reason, Plaintiffs clearly have standing.

B.        Plaintiffs justifiably relied on PWC’s unqualified audits of HPL in deciding to sell their shares of CTG for shares in HPL.

 

1.         Plaintiffs directly relied.

 

Contrary to the false and misleading statements made by PWC in its Motion, Plaintiffs Scott Lane, Kenneth Schibler and Howard Tigelaar directly relied upon the statements contained in PWC’s Report of Independent Auditors in deciding to exchange their stock in CTG for stock in HPL.  As for Scott Lane, he testified in his deposition that he received two copies of the Private Placement Memorandum, which contained the PWC-audited financials, and retained both copies because they looked important to him.  See Deposition of Scott Lane attached hereto as Exhibit F (“Lane Depo”) at p. 61.  He understood that PWC prepared the audited financial statements which were part of the Private Placement Memorandum.  Id. at p. 62.  He stated that he skimmed pages 1 through 98 of the Private Placement Memorandum, which included financial information regarding HPL.  Id. at 63.  He specifically stated that he read the Prospectus containing the audited HPL financials and focused on the annual audit performed by PWC.  Id. at 65-66.  In his deposition, he confirmed his interrogatory response, in which he stated that he reviewed and relied on the statements and representations by PWC in its Report of Independent Accountants in deciding to exchange his shares in CTG for shares in HPL.  Id. at 96-97.  He concluded by stating that he understood that PWC “performed an audit and that they – the statements were free of misrepresentations and that they had a – a basis for their opinion.  So that’s what I relied upon and I relied upon their paragraph on the financial statement.”  Id. at 98.

Despite this wealth of evidence that Mr. Lane relied upon PWC’s statements and its Report of Independent Accountants in agreeing to the merger, PWC states in its Motion that although Lane may have skimmed parts of the Prospectus, he “relied on the Covalar management team, not the PWC report.”  Motion at p. 11.  This statement is simply false.  In fact, the citation given by PWC for this statement, particularly pages 103-104 of Mr. Lane’s deposition, indicates to the contrary.  In his deposition, Mr. Lane stated that his interrogatory response in which he listed various statements from the Report of Independent Accountants that he relied upon was accurate and confirmed that “in addition to this Report of Independent Accountants by PWC” he relied on the decision of Mark Harward and CTG’s management to sell his shares in CTG.  Id. at pp. 102-103.  PWC’s statement that Lane relied solely on the Covalar management team is simply false and misleading.

The uncontroverted deposition testimony of Kenneth Schibler also reveals that he directly relied upon PWC’s misrepresentations in deciding to sell his shares in CTG for shares in HPL.  For example, Mr. Schibler stated in his deposition that he received and read the entire Joint Information Statement, which included PWC’s Report of Independent Accountants.  See Deposition of Kenneth Schibler attached hereto as Exhibit G at pp. 79-80.  He also stated that he specifically read most of Appendix D, which contained the Prospectus, including the audited HPL financial statements.  Id. at pp. 82-83.  Mr. Schibler also testified that the financial information of HPL was an important factor in his decision to sell his shares of CTG.  Id. at pp. 93, 131.  Schibler also testified that he felt he did not need to personally look behind HPL’s financial information contained in the Prospectus to determine whether it was accurate because he “knew that a good portion of it was audited, and I suppose they had auditing procedures in place” and so he “felt the data could be relied upon.”  Id. at 132.  He also confirmed in his deposition his interrogatory answers in which he laid out five different statements of PWC on which he relied in deciding to sell his shares in CTG.  See id. at pp. 207-210.  In fact, in its Motion, even PWC concedes that Mr. Schibler claims to have read HPL’s Prospectus in detail.  Motion at p. 11.

Despite the foregoing evidence, PWC claims that Mr. Schibler “relied on Harward and Stoner for his decision.”  Id. This statement is patently false, as Mr. Schibler actually stated in his deposition at the page cited by PWC as follows:

Q.        (BY MS. DONCH)  Going back to the last paragraph of your interrogatory response.  You indicate that the plaintiffs sold CTG for HPL stock based, in part, on the representations made by PWC and the documents; is that correct?

A.        That’s correct.

Q.        I want to focus on the “in part” part of that answer and ask if you can tell me what other things that you understand the plaintiffs relied on in deciding to sell CTG for HPL stock?

A.        I have knowledge that PWC is not the only document that I reviewed and my decisions to sell were made on a collective value but significantly bias based on the financial performance and expectations thereof.

Q.        (BY MS. DONCH)  And when you say on a collective basis, you’re referring to, also, relying on Mr. Harward and Ms. Stoner’s decision; is that correct?

A.        Yes.

Id. at p. 220 (emphasis added).  While Schibler may have relied in part on Harward and Stoner for his decision, he unquestionably relied upon PWC’s misrepresentations as well.

Finally, it is also clear that Plaintiff Howard Tigelaar relied upon PWC’s misrepresentations in deciding to sell his stock in CTG.  In his deposition, Mr. Tigelaar testified that he flipped through and read parts of the Joint Information Statement containing the PWC-audited financials of HPL in reaching a decision to sell his shares of CTG.  See Deposition of Howard Tigelaar attached hereto as Exhibit H at pp. 92-98.  He specifically stated that he looked at PWC’s audited balance sheets and understood that they had been prepared in collaboration with HPL’s auditors.  Id. at pp. 94-95.  Despite Tigelaar’s testimony, PWC falsely states in its Motion that he relied on the Covalar management team and not the PWC report in agreeing to sell his shares in CTG.  Motion at p. 11.  The deposition testimony cited for this proposition, however, merely states that Mr. Tigelaar relied in part on Mark Harward and Brenda Stoner to diligently analyze the available information and recommend a course of action in the best interests of CTG.  Id. at 189-190.  Elsewhere in his deposition, however, Mr. Tigelaar clearly stated that he reviewed information provided as part of the merger, including the Prospectus, in reaching his decision to convert his CTG stock to stock in HPL. Id. at pp. 190-191.  In fact, when counsel for PWC tried to get Mr. Tigelaar to agree that he relied solely on the opinions of Mark Harward and Brenda Stoner and did not rely on documents that he had read, he refused to agree, instead stating that “I didn’t rely only on the documents, you know, and my interpretation of them, I relied heavily on Mark and Brenda.”  Id. at p. 103.  Based on the foregoing evidence, it is clear that Tigelaar, Schibler and Lane directly relied on PWC’s misrepresentations in deciding to sell their shares in CTG for shares in HPL.[2]

2.         Plaintiffs indirectly relied.

 

In addition to directly relying on PWC’s misrepresentations, several of the Plaintiffs indirectly relied on such misrepresentations in deciding to sell their stock in CTG for stock in HPL.  Under Texas law, “[i]ndirect reliance is sufficient to support a fraud claim where the misrepresentation was made to an intermediary.”  Ameristar Jet Charter, Inc. v. Signal Composites, Inc., No. Civ. A. 398CV1360M, 2001 WL 1172184 at *5 (N.D. Tex. Sept. 28, 2001).  In J.C. Hawkins v. Upjohn Co., 890 F. Supp. 609 (E.D. Tex. 1994), a group of consumers brought suit against a pharmaceutical manufacturer for conspiring to commit fraud in marketing an unreasonably dangerous product.  The manufacturer moved to dismiss the complaint.  In arguing that the Court should dismiss the claim for conspiracy to commit fraud, Upjohn argued that the plaintiffs could not show reliance since the alleged misrepresentations were made to the FDA in order to persuade it to approve marketing of the drugs rather than being made directly to the plaintiffs.  The Court rejected this argument, recognizing that a claim for fraud can proceed based on indirect reliance, stating as follows:

The only element arguably lacking in plaintiffs’ complaint is that of plaintiffs’ acting in reliance on the material misrepresentation, since there is no allegation that plaintiffs relied directly on any representation made by defendants.  However, the allegation of indirect reliance is clear.  Plaintiffs assert that the FDA relied on defendant’s representations in permitting the distribution of the drugs in question within the United States and that plaintiffs relied on the FDA’s assessment as to the drugs’ safety in choosing to use the drugs. Such indirect reliance is sufficient to state a claim of fraud.

Id. at 612.

It is unquestioned that Plaintiffs Harward, Stoner and Wertheimer relied on the misrepresentations made by PWC in the audited financials; PWC does not claim in its Motion that these three plaintiffs are unable to show reliance.  There is also ample evidence that the other CTG shareholders relied on Harward, Stoner and Wertheimer – officers and controlling shareholders of CTG – in deciding to sell their shares in CTG.  For example, Plaintiff Shetti agreed in his deposition that in making his decision to sell his shares in CTG to HPL, he “relied upon Mr. Harward, Mrs. Stoner and Mr. Wertheimer, and the others at CTG to diligently analyze information then available to them.”  Deposition of Mahant Shetti attached hereto as Exhibit I at p. 72.  Similarly, Plaintiff Angela Harward testified that she relied on the decision of her husband, Mark Harward, to sell CTG to HPL and to “diligently analyze the information then available to him in reaching his decision on whether or not to sell CTG to HPL and then recommend a course of action that was in the best interests of CTG and its shareholders.”  Deposition of Angela Harward attached hereto as Exhibit J at p. 25.  Plaintiff Tom Stoner similarly testified that he relied on his wife, Brenda Stoner, and on Mark Harward to diligently analyze information available to them while reaching their decision.  Deposition of Tom Stoner attached hereto as Exhibit K at p. 42.  Plaintiffs Mary Schibler, Cathy Tigelaar and Candace Lane testified that they each relied upon their husbands, who relied on PWC’s audited financials, to decide whether to exchange their shares in CTG for shares of HPL.  See Deposition of Mary Schibler attached hereto as Exhibit L at pp. 18-19; deposition of Cathy Tigelaar attached hereto as Exhibit M at pp. 49-50; deposition of Candace Lane attached hereto as Exhibit N at pp. 14-15.  As set forth above, such indirect reliance is more than adequate under Texas law.[3] For this reason, the Motion should be denied as to Plaintiffs’ claims for negligent misrepresentation.

3.         Reliance is a fact question.

 

Finally, summary judgment on Plaintiffs’ negligent misrepresentation claim should be denied because issues of reliance present fact questions that are inappropriate for summary judgment.  See, e.g., Jones v. Ray Ins. Agency, 59 S.W.3d 739, 754 (Tex. App.–Corpus Christi 2001, pet. denied) (“ordinarily the issue of reliance in a fraud case is a question of fact”); Dan Lawson & Assoc. v. Miller, 742 S.W.2d 528, 530 (Tex. App.– Fort Worth 1988, no writ) (“Summary judgment should never be granted when the issues are inherently those for a jury or trial judge, as in cases involving intent, reliance, reasonable care, uncertainty and the like.”); Hilton v. Texas Investment Bank, 650 S.W.2d 545, 547 (Tex. App.–Houston [14th Dist.] 1983, no writ) (same).  The evidence set forth above clearly creates an issue of fact regarding Plaintiffs’ direct and indirect reliance which renders summary judgment inappropriate.

II.        The Motion should be denied as to Plaintiffs’ claims for common law fraud because   Plaintiffs are within the class of persons whom PWC had reason to expect would rely on      its unqualified audits of HPL.

 

Under the facts of this case, PWC clearly had a reason to expect Plaintiffs would rely on its unqualified audit opinions of HPL.  As set forth above, PWC knew that HPL intended to supply the audited financials to a limited group of persons including Plaintiffs herein as shareholders of acquisition target CTG.  First, the IPO Prospectus into which the PWC-audited financials were incorporated clearly stated that HPL intended on pursuing strategic acquisitions.  See Exhibit A at pp. 2, 10.  And Doug Brown, one of the lead auditors on the HPL audit project, stated in his deposition that he was aware at the time the Prospectus was issued in June 2001 that HPL was contemplating acquiring Fabcentric and that PWC would be auditing Fabcentric.  See Brown Depo  at pp. 328-29; Exhibit C.  Not only was PWC specifically aware of the ongoing discussions with Fabcentric regarding its potential acquisition, but it also knew that other potential acquisition targets would likely review the IPO Prospectus and financials contained therein.  Brown Depo at pp. 51, 326.  Finally, PWC learned shortly after the Prospectus was issued that HPL was contemplating acquiring CTG in particular.  Scarpelli Depo at pp. 115, 120-21, 129-30.

In Reisman v. KPMG Peat Marwick, LLP, 781 N.E.2d 821, 829 (Mass. Ct. App. 2003), the Reisman family sold their interest in their family business for shares of stock in a company called Marcam.  In agreeing to sell their company, valued at $23 million, they “relied heavily” on financial statements of Marcam audited by Peat Marwick.  Id. at 826.  After the sale closed, the value of their Marcam stock took a “steady and precipitous plunge.”  Id. at 823.  Eventually Marcam restated its financial reports, admitting that the reports upon which the Reismans had relied overstated Marcam’s revenues.  Id. The Reismans brought suit against Peat Marwick for, among other claims, fraud.  When the trial court granted summary judgment to Peat Marwick, they appealed.  The Massachusetts Court of Appeals reversed, finding that the Reismans were within the class of persons Peat Marwick had a reason to expect would rely on its audit opinions.  The court explained its reasoning as follows:

We are of the opinion that an accounting firm that, in its role as auditor, falsely certifies a company’s annual report as being free from material misstatement has reason to expect at the time it so certifies that its statement will be relied upon by potential investors; this is particularly so when it is aware that there is a limited subgroup of investors – those whose companies its client company wishes to acquire – to whom such financial reports will, in all likelihood be furnished.

Id. at 829; see also McGann, 102 F.3d at 396-97 (court held that by producing fraudulent audit report accounting firm knew would be included in client’s 10-K, accounting firm made false assertions “in a manner reasonably calculated to influence the investing public.”); Restatement (Second) of Torts § 531, comment e (the class to whom a person making fraudulent misrepresentations may be held liable “may include a rather large group, such as potential sellers, buyers, lenders, creditors or investors, or others who may be expected to enter into dealings in reliance upon the misrepresentation.”).[4] As the Fifth Circuit has observed:

[t]he danger of misleading the public through a public accountant’s knowing issuance of a false opinion is obvious.  A public accountant performs an important public function and must be aware that the public places great faith in the probity of its opinions.

Fine v. American Solar King, 919 F.2d 290, 300 (5th Cir. 1990).  PWC’s Motion should be denied.

III.       The Motion should be denied as to Plaintiffs’ statutory fraud claim.

A.        Plaintiffs need not show that PWC made direct misrepresentations to them.

 

PWC cites Westcliff v. Wall, 267 S.W.2d 544 (Tex. 1954) for the proposition that Plaintiffs must show that PWC made direct misrepresentations to them in order to sustain their claim for statutory fraud under Section 27.01.  See Motion at p. 16.  In the fifty years since that case was published, however, Texas courts have moved away from the previous privity requirement in actions for fraud.  In fact, the Texas Supreme Court recently rejected an accounting firm’s attempt to rely on Westcliff as a basis for its argument that the court should dismiss the fraud claim brought against them by a group of investors because the investors could not show that the accounting firm specifically intended to influence them.  See Ernst & Young, 51 S.W.3d at 578.  More recently, the Houston Court of Appeals in Kanon v. Methodist Hosp., 9 S.W.3d 365, 372 (Tex. App. – Houston [14th Dist.] 1999, no pet.) cited Westcliff for the proposition that a fraud plaintiff must demonstrate that the defendant misrepresented a fact directly to them; in other words, that there was privity.  The Texas Supreme Court in Ernst & Young specifically disapproved of the holding in Kanon “to the extent it suggests that Texas law requires privity to establish fraud.”  Ernst & Young, 51 S.W.3d at 580.

Most importantly, the Texas Supreme Court in Ernst & Young clearly rejected the notion that fraudulent statements need to be made directly to a specifically identifiable person or entity in order for fraud liability to attach:

Our fraud jurisprudence has traditionally focused not on whether a misrepresentation is directly transmitted to a known person alleged to be in privity with the fraudfeasor, but on whether the misrepresentation was intended to reach a third person and induce reliance.

Id.; see also Burroughs v. APS Int’l, Ltd., 93 S.W.3d 155, 162 (Tex. App. – Houston [14th Dist.] 2002, pet. denied) (In order to state a claim for fraud, “The misrepresentation does not have to be made directly to the particular person seeking relief.”); Restatement (Second) of Torts §531, comment e, ill. 4 (“A, a certified public accountant, fraudulently certifies an erroneous balance sheet for B company.  A is informed that B company intends to exhibit the balance sheet to one or more of a group of banks or other lenders or investors for the purpose of obtaining a loan.  A does not know the identity of any of the persons whom B company may decide to approach.  B company exhibits the balance sheet to C company, which, in reliance upon it, makes a loan to B company and as a result suffers pecuniary loss.  A is subject to liability to C company.”).

It is clear that to state a claim for common law fraud under Texas law, a plaintiff need not show that the defendant made fraudulent representations “directly to them for the purpose of exerting direct influence over them.”  Motion at p. 16.  It is equally clear that the elements of a statutory fraud claim and a common law fraud claim are identical in this respect.  See, e.g., Trinity Industries, Inc. v. Ashland, Inc., 53 S.W.3d 852, 867 (Tex. App. – Austin 2001, pet. denied) (“The elements of statutory fraud under Section 27.01 of the Texas Business and Commerce Code are essentially identical to the elements of common law fraud except that Section 27.01 does not require proof of knowledge or recklessness as a prerequisite to the recovery of action damages.”); Stephens v. Halliburton Co., No. Civ. A. 3:02-CV-1442-L, 2003 WL 22077752 at *7 (N.D. Tex. Sept. 5, 2003) (same).  PWC cites no cases for the proposition that a Section 27.01 statutory fraud claim requires a demonstration of privity, which clearly is not part of Texas fraud jurisprudence.  And the stated elements of a statutory fraud claim do not include any privity requirement.  See Tex. Bus. & Comm. Code §27.01(a).  For this reason, PWC’s argument that it is entitled to summary judgment on Plaintiffs’ statutory fraud claim should be rejected.

B.        PWC’s misrepresentations were made in part to induce shareholders like Plaintiffs to enter into contracts with HPL.

 

PWC argues that it is entitled to summary judgment on Plaintiffs’ statutory fraud claim because there is no evidence that PWC made any representations for the purpose of inducing Plaintiffs to enter into a contract.  First, the Court should be aware that the contract at issue need not be between the plaintiff and the defendant.  See, e.g., Mid States Development, L.L.C. v. Fidelity Nat’l Title Ins. Co., Inc., No. Civ. A. 399CV1966M, 2001 WL 1172215 at *5 (N.D. Tex. Sept. 28, 2001) (“Section 27.01 does not require that the operative contract be between Plaintiffs and Fidelity.”).  In the instant case, of course, the contracts at issue are the contracts between Plaintiffs and HPL whereby Plaintiffs sold their shares in CTG for shares in HPL.  There is ample evidence raising a fact issue as to whether PWC intended shareholders in companies HPL might acquire in the future to rely upon HPL’s audited financial statements in agreeing to a merger or acquisition by HPL.

As set forth above, PWC knew that HPL intended to supply the audited financials to a limited group of persons including Plaintiffs herein as shareholders of acquisition target CTG.  First, the IPO Prospectus into which the PWC-audited financials were incorporated clearly stated that HPL intended on pursuing strategic acquisitions.  See Exhibit A at pp. 2, 10.  And Doug Brown, one of the lead auditors on the HPL audit project, stated in his deposition that he was aware at the time the Prospectus was issued in June 2001 that HPL was contemplating acquiring Fabcentric and that PWC would be auditing Fabcentric.  Brown Depo at pp. 328-29; Exhibit C.  PWC also knew that other potential acquisition targets would likely review the IPO Prospectus and financials contained therein. Brown Depo at pp. 51, 326.  Finally, PWC learned shortly after the Prospectus was issued that HPL was contemplating acquiring CTG in particular.  Scarpelli Depo at pp. 115, 120-21, 129-30.  Because there is a fact question as to whether PWC intended to induce reliance by shareholders in companies that might be acquired by HPL, PWC’s Motion should be denied.  See, e.g., Fine v. American Solar King Corp., 919 F.2d 290, 298 (5th Cir. 1990) (“summary judgment should be used sparingly when motive and intent are factors.”).

C.        Plaintiffs are entitled to recover exemplary damages because there is ample evidence from which PWC’s actual awareness of the falsity of its representations may be inferred.

 

Under Section 27.01, a plaintiff may recover actual damages without a showing that the defendant had actual awareness of the falsity of his statements.  See Tex. Bus. & Comm. Code §27.01(a).  To recover exemplary damages, however, the plaintiff must show that the defendant made “a false representation or false promise with actual awareness of the falsity thereof ….”  Tex. Bus. & Comm. Code §27.01(c).  Actual awareness, however, “may be inferred where objective manifestations indicate that a person acted with actual awareness.”  Id. In the instant case, there is ample evidence from which PWC’s actual awareness of the falsity of its representations regarding HPL’s financial condition may be inferred.  Among the specific misrepresentations alleged by Plaintiffs are the following:

  1. PWC represented that HPL’s financial statements filed with the SEC were prepared in accordance with GAAP;
  2. PWC represented that the HPL financial information contained in the Report of Independent Accountants presented fairly, in all material respects, the financial position of HPL;
  3. PWC represented that its audit of HPL had been conducted in compliance with GAAS;.
  4. PWC represented that it had planned and performed its audit of HPL to obtain reasonable assurance about whether the financial statements were free of material misstatements; and
  5. PWC represented that it had a reasonable basis for its opinions regarding HPL’s financial statements.

The uncontroverted facts demonstrate that — at a minimum — a fact issue exists as to whether PWC had actual awareness of the falsity of these representations.  Among the “objective manifestations” from which such actual awareness may be inferred are the following

  • Even before the 2001 audit at issue, PWC had reason to suspect HPL’s revenue recognition practices since it had insisted that HPL write off nearly $2 million — or 35% — of its 2000 revenue as part of its 2000 audit.  See Exhibit O.
  • Following its 2000 audit, PWC drafted a management recommendation letter containing harsh criticisms of HPL, but watered down the letter before presenting the final version to HPL’s Board of Directors.
    • the draft letter noted that David Lepejian had the ability to override all decisions and to control revenue recognition, but that observation was omitted from the final version.  Brown Depo at pp. 85-87.
    • the draft letter recommended that HPL develop an accounting policies and procedures manual, to include policies related to revenue recognition, but this suggestion was omitted from the final version.  Brown Depo at pp. 88-89.
    • the draft letter noted that review of HPL’s cash, accounts receivable and accounts payable were not evidenced in writing and that without proper written documentation evidencing such review, “[i]t may become increasingly difficult for management to determine whether control procedures are being appropriately completed,” but this observation was omitted from the final version.  Brown Depo at pp. 90-91.
    • the draft letter recommended that HPL “implement a revenue management system that is integrated with the financial accounting package” but omitted this suggestion from the final version.  Brown Depo at pp. 91-92.
    • the draft letter questioned the effectiveness of HPL’s audit committee, but this criticism was omitted from the final version.  Brown Depo at p. 92.
    • the draft letter suggested that HPL hire an in-house legal counsel, but this suggestion was omitted from the final version.  Brown Depo at p. 98.
  • HPL responded to PWC’s watered-down recommendation letter by stating that it was “taking action to be compliant with SOP 97-2 and related amendments and is in the process of implementing a checklist for revenue recognition, including the required document.”
    • But PWC auditor Doug Brown admitted that he never saw any such checklist prepared by HPL.  Brown Depo at pp. 103-104, 106.
    • And PWC did not even ask anyone from HPL whether they had prepared the SOP 97-2 checklist even though PWC knew that revenue recognition was the primary risk of financial misstatement in the software industry and knew that HPL did not have much experience with revenue recognition and needed guidance from PWC.  Brown Depo at pp. 106-107.
  • HPL responded to PWC’s watered-down recommendation letter by stating that it was in the process of documenting and implementing accounting policies and procedures, including the maintaining of supporting documentation for all company transactions and formalizing policies and procedures for revenue recognition.
    • But PWC’s Doug Brown does not recall whether HPL ever documented or implemented such procedures.  Brown Depo at pp. 110-111.
  • HPL responded to PWC’s watered-down recommendation letter by stating that its CFO would present monthly financial statements to management.
    • But PWC’s Doug Brown stated he did not believe HPL ever did so.  Brown Depo at pp. 111-112.
  • HPL responded to PWC’s watered-down recommendation letter by stating that its CFO  would have a monthly meeting with all department vice presidents to present, review and analyze prior month’s financials and discuss material issues.
    • But PWC’s Doug Brown admitted that, to his knowledge, this never occurred.  Brown Depo at pp. 118-119.
  • Despite HPL’s failure to address the issues raised in PWC’s management recommendation letter, PWC’s March 31, 2001 risk assessment for HPL stated: “We issued a management letter last year with some strong control weaknesses.  Based on this management letter the company has addressed all of our concerns in the last five months.”
    • But Doug Brown admitted that he had not seen documentation indicating that HPL had addressed all of the concerns set forth in PWC’s September 2000 management recommendation letter and he therefore could not testify that this was a true statement by PWC.  Brown Depo at pp. 122-123.
  • At the time of its 2001 audit, PWC stated that Ita Geva, the CFO of HPL, was “weak.”  Brown Depo at pp. 70-72.
  • At the time of its 2001 audit, PWC stated that HPL was dominated by CEO David Lepejian, a fact which Doug Brown admitted could be a financial reporting risk.  Brown Depo at pp. 74-77.
  • At the time of its 2001 audit, PWC knew that Mr. Lepejian controlled revenue recognition and had the ability to override the decisions of anyone else in the company.  Brown Depo at pp. 81-83.
    • At the time of its 2001 audit, PWC knew that revenue recognition was the area most susceptible to material misstatement.  Id.
  • PWC’s risk analysis of HPL prior to its 2001 audit stated that:
    • HPL was dominated by one or a few individuals;
    • Ita Geva, the CFO of HPL, was weak and might become overwhelmed by her duties as HPL began to grow;
    • HPL’s Board was passive or lacked independence from management;
    • HPL’s management was “under pressure for more favorable earnings;”
    • HPL’s audit committee lacked independence from management or lacked the necessary authority or resources to adequately investigate matters.  Brown Depo at pp. 124-126, 152.
  • The overall risk factor PWC gave to its audit of HPL increased from a factor of 31 in 2000 to a factor of 36 in 2001.  Among the increases were the following:
    • an increase regarding the incentive for intentional misstatements in financial reporting from two to three (on a scale from one to five);
    • an additional risk factor due to HPL’s operations in locations that have evidenced significant ethical shortfalls;
    • an increased risk factor based on HPL’s unsuccessful IPO;
    • an additional risk factor based on the termination of HPL’s relationship with its prior underwriter;
    • an increase in the integrity and conduct risk factor from a two to a three;
    • an additional risk factor based on the fact that HPL’s Board of Directors was passive and lacked independence from management; and
    • an increase in the risk factor relating to revenue recognition from a two to a three.  Brown Depo at pp. 137-147.
  • Although Doug Brown testified the foregoing risk factors were one of the reasons PWC recommended that HPL hire an additional controller, he admitted that HPL never did so prior to the end of the 2001 HPL audit.  Brown Depo at pp. 126-127.
  • Despite all of the increased risk factors mentioned above, PWC believed that HPL had improved its internal controls from 2000 to 2001 because of the hiring of Ita Geva as HPL’s CFO, despite the fact that PWC’s own documents described her as “weak.”  Brown Depo at pp. 148-149, 156-158.
  • PWC recommended that HPL review all material contracts with PWC prior to their signing, something Doug Brown admitted he had never seen PWC recommend to any other client.  Brown Depo at pp. 96-97.
    • Despite the recommendation that PWC review all of HPL’s material contracts prior to signing, Doug Brown, the lead auditor for HPL, admitted that he never did so.  Brown Depo at pp. 102-103.
  • More than 80% of HPL’s revenue for the quarter ending March 31, 2001, was invoiced on the last day of the quarter, a Saturday, a fact which Doug Brown admitted raised a concern in his mind.  Brown Depo at pp. 184-186; Exhibit P.
  • Although acceptance and installation are a critical component of revenue recognition under SOP 97-2, PWC’s revenue testing for HPL’s revenue for the quarter ending March 31, 2001 omitted such information with respect to six transactions comprising approximately 80% of the revenue for the quarter.  Brown Depo at pp. 197-198; Exhibit P.
  • During its 2000 audit, PWC recognized that the Dominion contract had acceptance criteria and that revenue could not be recognized until the contract was completed and final customer acceptance was achieved.  Brown Depo at pp. 295-96; Exhibit O at PWC 81945-46.
    • Despite this recognition, PWC allowed HPL to record revenue from the Dominion contract piecemeal throughout 2001, which Brown admitted was inconsistent with the way Dominion revnue was treated in the 2000 audit.  Brown Depo. at pp. 297-30.
  • Doug Brown admitted that before revenue could be recognized from sales to Canon, PWC’s largest customer and a reseller in Japan, Canon needed to deliver the product to the end user.  Brown Depo at pp. 179-180.
    • But PWC never had any verbal communications with any of the end users that purchased software from Canon and never sent purchase confirmations to any of such end users, instead relying solely on confirmations from Canon.  Brown Depo at pp. 179-180, 208, 221-222, 233-234.
    • Doug Brown could offer no explanation as to why customer confirmations for sales to Canon were sent to Canon as opposed to its end users.  Brown Depo at p. 310.
  • Audit partner Michael Scarpelli admitted that PWC never reviewed purchase orders from any end users of Canon, and explained that David Lepejian had told him that Canon did not want to give such PO’s to HPL because Canon was bundling its software with other products it was selling.  Scarpelli Depo at pp. 170-171.
  • PWC reversed one transaction with Canon as part of its 2001 audit because Canon did not have a final purchase order from its end user.
    • But PWC failed to reverse two identical transactions occurring on the same day as the reversed transaction, which had revenue totaling more than $1.8 million, and could offer no explanation as to why those two transactions were treated differently than the one it reversed.  Brown Depo at pp. 199-209, 215; Exhibit P.
  • PWC’s own documents indicated that “Reseller arrangements have historically contributed an unusually high level of troublesome revenue recognition situations that have led to restatements.”  Brown Depo at p. 235.
  • PWC’s own documents indicated that resellers presenting “the highest risk of uncertainty as to whether revenue should be recorded upon the delivery of a product” include those that are significant customers, those that are significantly larger than the vendor and those that are international, factors which each apply to Canon.  Brown Depo at pp. 235-237.
  • Although Doug Brown admitted that sales that HPL made through Canon had a high risk of financial misstatement, no one from PWC, including anyone from their Tokyo office, ever spoke to or met with Canon.  Brown Depo at pp. 237-238.
    • Brown admitted that given information PWC subsequently learned, “perhaps it would have been prudent” for someone from PWC to sit down with Canon face to face and confirm its relationship with HPL.  Brown Depo at p. 240.
  • In deciding whether installation of HPL’s software was essential to its functionality, a critical component of revenue recognition under SOP 97-2, PWC relied solely on discussions with HPL management and never spoke with any of HPL’s customers.  Brown Depo at pp. 243-250.
    • Doug Brown admitted that “perhaps it would have been better” for PWC to have sent sales confirmations to Canon’s end-users rather than to Canon.  Brown Depo at p. 256.
  • Despite admitting that installation was required prior to revenue recognition on certain HPL transactions, Doug Brown admitted that he never looked at any of HPL’s detailed project plans which discussed such things as installation.  Brown Depo at pp. 285-286.
    • Brown admitted that it would have been helpful for PWC to understand the service elements of HPL’s software sales to have looked at HPL’s project plans, but admitted that he never did so and instead relied solely on Ita Geva and David Lepejian for such information.  Brown Depo at p. 318.
  • Brown and Scarpelli testified that the only thing PWC did to understand the installation and customization process for software sold to end users was to speak with Ita Geva and David Lepejian, and that he does not recall speaking to any of HPL’s customer support engineers.  Brown Depo at pp. 259-260; Scarpelli Depo at pp. 185-187.
  • Doug Brown admitted that he never utilized PWC’s SOP 97-2 checklist during his work on the 2000 or 2001 HPL audits despite the fact that PWC stated in its internal documents that it was going to test revenue recognition for HPL’s contracts by completing the SOP 97-2 revenue recognition checklist.  Brown Depo at pp. 262-267.
  • Although Doug Brown stated in his performance review that one of the things he wanted to work on was talking to non-financial personnel of his clients to gain a better understanding of their business, he admitted that he never did so with respect to HPL.  Brown Depo at pp. 317-318.
  • HPL’s day sales outstanding (“DSO”), the number of days it took for customers to pay, ranged from 128 to 198 days.  Exhibit Q.
  • Doug Brown admitted that the only customer confirmations PWC received from HPL’s customers were fax confirmations rather than originals or oral confirmations, and admitted that an original confirmation is more reliable than a fax.  Brown Depo at p. 304.
    • One of the customer confirmations received from Canon, which confirmed a balance owed to HPL of nearly $6 million and which turned out to be fraudulent, was clearly sent by a fax machine at the headquarters of ST Microelectronics in France, one minute before ST Microelectronics sent a similar confirmation to PWC, providing clear evidence that the Canon confirmation was fraudulent.  See Exhibit R.

Such evidence clearly raises an issue of fact regarding PWC’s state of mind.  See, e.g., In re Ikon Office Solutions, Inc., 277 F.3d 658, 677 n.26 (3d Cir. 2002) (“in many cases the most plausible means to prevail on a section 10(b) claim against an auditor — without that ever-elusive ‘smoking gun’ document or admission — will be to show how specific and not insignificant accounting violations collectively raise an inference of scienter.”).  Because this evidence creates a fact question regarding actual awareness, PWC’s Motion must be denied.

IV.       The Motion should be denied as to Plaintiffs’ claim for aiding and abetting statutory fraud.

 

A.        There is ample evidence from which PWC’s actual awareness of the falsity of its  representations may be inferred.

As set forth above in Section III.C., there is ample evidence from which PWC’s actual awareness of the falsity of its     representations may be inferred.  Plaintiffs adopt and incorporate by reference herein the evidence, argument and authorities cited in Section III.C above.

B.        PWC clearly derived a benefit from its false representations in HPL’s prospectus

As HPL’s auditor, PWC clearly derived a benefit from its false representations in HPL’s prospectus.  PWC audit partner Michael Scarpelli testified that PWC billed HPL approximately $400,000 for its work on HPL’s IPO.  Scarpelli Depo at pp. 101-102.  He further testified that the IPO and audit work would have yielded fees to PWC of approximately $700,000.  Scarpelli Depo at p. 197.  PWC employee Doug Brown further testified that PWC had collected only 50% of the amounts it billed on HPL’s aborted IPO in the year 2000.  Brown Depo. at pp. 53-4.  With respect to its work for the 2001 IPO, Brown testified that HPL may not have had enough money to pay PWC’s fees if the IPO had not been successful.  Brown Depo. at pp. 53-6.  And Michael Scarpelli admitted that PWC’s unqualified audit opinion of HPL was necessary for the 2001 HPL IPO to go forward.  Scarpelli Depo. at p. 138.  Under such circumstances, it is clear that PWC derived a benefit from its false representations in HPL’s IPO Prospectus.

V.        The Motion should be denied as to Plaintiffs’ claim for aiding and abetting a violation of the Texas Securities Act.

 

A.        The evidence creates a fact issue as to whether PWC acted recklessly in making the misrepresentations which aided and abetted HPL’s securities fraud.

 

1.         Plaintiffs need not show that PWC had a “general awareness” of its role in the primary violation; rather, Plaintiffs need only show that PWC acted recklessly.

 

PWC claims in its Motion that to state a claim against PWC as an aider and abettor under the Texas Securities Act, Plaintiffs must demonstrate that PWC had a “general awareness” of its role in HPL’s primary violation.  Motion at p. 19.  A close examination of the Texas Securities Act and Texas law interpreting and applying the Act, however, demonstrates the falsity of this proposition.  First and foremost, the Texas Securities Act does not state that “general awareness” is an element of a cause of action under that Act.  Rather, it states as follows regarding aider and abettor liability:

A person who directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aids a seller, buyer, or issuer of a security is liable under Section 33A, 33B or 33C jointly and severally, with the seller, buyer, or issuer, and to the same extent as if he were the seller, buyer, or issuer.

Tex. Rev. Civ. Stat. Ann. art. 581-33(F)(2) (Vernon 2003).

Moreover, the cases PWC cites for its “general awareness” argument lack support.  For example, PWC cites Frank v. Bear Stearns & Co., 11 S.W.3d 380 (Tex. App. – Houston [14th Dist.] 2000, pet. denied) for the proposition that a plaintiff must show that the defendant had general awareness of its role in the primary violation to be liable as an aider and abettor under the Texas Securities Act.  The Frank case merely cited a law review article for this novel proposition.  See Frank, 11 S.W.3d at 384.  The two Texas cases cited by that law review article were Abbott v. Equity Group, Inc., 2 F.3d 613 (5th Cir. 1993) and Insurance Co. of North America v. Morris, 928 S.W.2d 133 (Tex. App. – Houston [14th Dist.] 1996), rev’d in part on other grounds, 986 S.W.2d 667 (Tex. 1998).  The Court of Appeals in Morris, however, merely stated that the trial court had instructed the jury that it had to show general awareness of the primary violation and that the evidence adduced at trial satisfied this burden; at no point did the Court of Appeals or the Texas Supreme Court adopt the general awareness test advocated by PWC.  And in Abbott, the court merely cited another Fifth Circuit case, Abell v. Potomac Ins. Co., 858 F.2d 1104 (5th Cir. 1998), which interpreted Rule 10b-5 of the Federal Securities Act and which has been vacated.  Finally, the case of Crescendo Investments, Inc. v. Bryce, 61 S.W.3d 465, 472 (Tex. App. – San Antonio 2001, pet. denied) merely cited Frank for the proposition that general awareness is an element under the Texas Securities Act.  Simply put, nothing in any of the cases cited by PWC stands for the proposition that a plaintiff proceeding under the Texas Securities Act need show that an aider and abettor had general awareness of its role in the primary violation in order to be subject to liability.

A recent case by the Fort Worth Court of Appeals demonstrates the fallacy of PWC’s argument.  In Sterling Trust Co. v. Adderley, No. 2-00-336-CV, 2003 WL 21770799 (Tex. App. – Fort Worth July 31, 2003, pet. filed), the Court rejected the notion that “general awareness” was an element of aider and abettor liability under the Texas Securities Act.  See id. at *3.  The Court noted that the Texas Securities Act contained no language which would support the necessity of demonstrating general awareness.  Id. Moreover, the Court closely scrutinized the Frank and Crescendo cases, noting that the Frank opinion relied heavily on a law review article interpreting the Texas Securities Act in light of the Federal Securities Act and that the Crescendo opinion relied solely on FrankId. The Court also held that in Morris, the trial court’s jury instruction that an aider and abettor must be aware of the securities law violation was not challenged on appeal and that the Texas Supreme Court merely reviewed the evidence to support the aider finding in light of the charge submitted.  Id. at *3.  The Fort Worth Court of Appeals noted:

The language of the TSA does not require proof that an aider is generally aware of its role in the securities violation to be liable as an aider.  Because we must give effect to the TSA as written by the legislature, we hold that the trial court did not abuse its discretion by failing to give Sterling’s requested jury instruction on general awareness.

 

Id. at *4.

As set forth above, a plaintiff need not show that an aider and abettor acted with general awareness of the primary violation at issue.  Rather, the plaintiff must merely show that the aider and abettor acted with an “intent to deceive or defraud or with reckless disregard for the truth or the law.” Tex. Rev. Civ. Stat. Ann. art. 581-33(F)(2) (Vernon 2003);  In re Triton Energy Ltd. Sec. Litig., No. 5:98-CIV-256, 2001 WL 872019 at *10 (E.D. Tex. March 30, 2001) (“Severe recklessness does not require that the defendant be aware of the actual falsity of his or her representation.”).

2.         The evidence creates a fact issue as to whether PWC acted recklessly.

 

The evidence creates a fact issue as to whether PWC acted with reckless disregard for the truth or law or with an intent to deceive or defraud. As set forth above in Section III.C., incorporated by reference herein, there is ample evidence that PWC was aware of the falsity of its representations.[5] In addition to this evidence, the evidence of the reaudit of HPL shows the magnitude of PWC’s misrepresentations, as illustrated below:

Total Revenues – software licenses, consulting services, maintenance and other 2001 2002
As originally reported and included in audited financial statements $13,419,000 $37,514,000
As restated $4,315,000 $4,513,000
Percent change (68%) (88%)

 

Income (loss) from continuing operations before income taxes (pre-tax earnings/(loss)) 2001 2002
As originally reported and included in audited financial statements $2,154,000 $13,754,000
As restated $(6,245,000) $(15,825,000)
Percent change (390%) (215%)

 

Net income/(loss) 2001 2002
As originally reported and included in audited financial statements $541,000 $6,744,000
As restated $(6,435,000) $(14,917,000)
Percent change (1,289%) (321%)

 

Regan Affidavit attached hereto as Exhibit S at par. 8.  Several courts have held that the magnitude of the misstatements at issue is probative of fraudulent intent and recklessness. See, e.g., In re Worldcom Sec. Litig., No. 02 Civ. 3288, 2003 WL 21488087 at * 7 (S.D.N.Y. 2003) (“Although the size of the fraud alone does not create an inference of scienter, the enormous amounts at stake, coupled with the detailed allegations regarding the nature and extent of WorldCom’s fraudulent accounting and Anderson’s failure to conduct a thorough and objective audit create a strong inference that Anderson was reckless in not knowing that its audit opinions materially misrepresented WorldCom’s financial state.”); In re First Merchants Acceptance Corp. Sec. Litig., No. 97 C 2715, 1998 WL 781118 at *10 (N.D. Ill. Nov. 4, 1998) (“Other circumstances suggesting fraudulent intent can include the presence of ‘red flags’ or warning signs that the financial reports are fraudulent, as well as the magnitude of the fraud alleged.”); In re Microstrategy, Inc. Sec. Litig., 115 F. Supp. 2d 620, 652 (E.D. Va. Sept. 2000) (“the greater the magnitude of the irregularities, and the more frequent the violations, the stronger is the inference that conscious fraud or recklessness is the explanation for the auditor’s role in the violations.”).  Based on the foregoing evidence, Plaintiffs’ expert, Paul Regan, is of the opinion that PWC acted recklessly. Affidavit of Paul Regan attached hereto as Exhibit S at pars. 17-19.

The relevant case law also supports an inference of recklessness under the uncontroverted facts of this case.  In the case of In re Microstrategy, Inc. Sec. Litig., 115 F. Supp. 2d 620 (E.D. Va. Sept. 2000), a group of investors brought a securities fraud class action against the corporation and PWC, the company’s accountant/auditor, alleging artificial inflation of the company’s stock price through improper revenue recognition.  In determining whether PWC acted with the requisite scienter, the court found that it was significant that the violations occurred over a long period of time, that the violations resulted in such a large restatement, that the violations involved violation of a relatively straightforward accounting principle regarding revenue recognition and that PWC was able to quickly identify and correct the accounting violations after the publication of a magazine article bringing them to light:

It is simply a matter of common sense and logic – particularly given the special expertise of accounting firms – that the less complex the rules violated, the greater the magnitude of the irregularities, and the more frequent the violations, the stronger is the inference that conscious fraud or recklessness is the explanation for the auditor’s role in the violations.  And, the fact that PWC was able quickly to identify and correct these violations from information accumulated for over two years weakens the inference that PWC acted with a non-culpable state of mind.

Id. at 652.

Many of the foregoing facts are present in the instant case, as Plaintiffs allege that PWC violated the same revenue recognition principles that the plaintiffs alleged in Microstrategy PWC violated, the violations took place over a long period of time and the magnitude of the irregularities was great.  And PWC and Deloitte and Touche were able to quickly identify the misstatements and correct them after HPL issued its July 19, 2002 press release.  See Deposition of Kerry Francis attached hereto as Exhibit T at pp. 82, 86, 104, 112, 121, 131.  Another similarity between the two cases involves the large amount of revenue HPL recognized on the last day of its fiscal year, March 31, 2001; in Microstrategy, the plaintiffs alleged that PWC failed to heed an audit risk alert issued by the AICPA stating that “auditors should be alert for significant unusual or complex transactions, especially those that occur at or near the end of a reporting period.  Also suspect are high volumes of revenues recognized in the last few weeks – or days – of a reporting period.”  Id. at 654.

Many courts have also recognized that the refusal to react to various “red flag” warning signs may evidence an auditor’s recklessness.  For example, with respect to proving recklessness, the court in Microstrategies stated that “[m]any courts have held that allegations that an auditor ignored ‘red flags’ is probative of fraudulent intent or recklessness.”  Id. at 653; see also In re The Leslie Fay Companies, Inc., 871 F. Supp. 686, 699 (S.D. N.Y. 1995) (“Allegations that, with gross recklessness, BDO ignored multiple ‘red flags’ could reasonably support an inference that BDO acted with intent.”); In re First Merchants Acceptance Corp. Sec. Litig., 1998 WL 781118 at *10 (“Other circumstances suggesting fraudulent intent can include the presence of ‘red flags’ or warning signs that the financial reports are fraudulent, as well as the magnitude of the fraud alleged.”); CMNY Capital, L.P. v. Deloitte & Touche, 821 F. Supp. 152, 166 (S.D. N.Y. 1993) (“An accountant can act recklessly by disregarding a ‘red flag’ in a given factual setting.”); In re Worldcom Sec. Litig., 2003 WL 21488087 at * 4 (finding evidence of recklessness where Arthur Andersen “failed to recognize the warning signs of fraud.”).  As the Eastern District of New York has recognized:

Similarly, in the present case, the plaintiffs have alleged that the violation of the auditing principles resulted in material misstatements of fact in the financials, and that BDO failed to follow proper audit procedures.  These allegations, combined with the allegations of BDO’s ignorance of numerous “red flags,” are adequate to suggest that BDO turned a blind eye to health management’s fraudulent activities, thus creating a “strong inference “ of BDO’s recklessness.

In re Health Mgmt., Inc. Sec. Litig., 970 F. Supp. 192, 203 (E.D. N.Y. 1997).

In Carley Capital Group v. Deloitte & Touche, L.L.P., 27 F. Supp. 2d 1324 (N.D. Ga. 1998), a group of investors, including those whose investment occurred in connection with a merger in which they exchanged shares of HDS stock for shares of Medaphis stock, brought suit against Medaphis’ accountants for violations of the federal securities law.  One of the plaintiffs’ primary allegations involved the premature recognition of revenue from software licensing agreements, allegations similar to the allegations made by Plaintiffs herein.  See id. at 1329-1330.  The plaintiffs also alleged that “because of the materially false and misleading statements” included in Medaphis’ financial statements, “Medaphis was able to continue its practice of acquiring companies with artificially-inflated Medaphis stock.”  Id. at 1331.  In ruling on the accountant’s Motion to Dismiss, the court noted that “[w]hile alleging a misapplication of Generally Accepted Accounting Principles standing alone is insufficient, such allegation when combined with a drastic overstatement of financial results can give rise to a strong inference of scienter.”  Id. at 1339.  Among the facts giving rise to such a strong inference of scienter, the court held, was the fact that “[t]he end of quarter revenue manipulations in 1995 and 1996 were highly suspicious, and a prudent auditor would have been on notice to inquire further even if it was not directly responsible for the manipulations.”  Id. at 1340.  Of course, the same could be said in this case of HPL’s significant end of quarter transactions with Canon and other customers.  Finally, with respect to the materiality of the financial misstatements, the court noted that “[b]ut for these alleged accounting rule violations, Medaphis could not have perpetuated its image as a high growth stock.  The overstatement of Medaphis’ financial condition, in turn, helped to allow Medaphis the opportunity to acquire other companies based on its artificially-inflated stock prices.”  Id. at 1339-1340.  The same could obviously be said in the instant case, in which HPL used its artificially-inflated stock in order to procure the Plaintiffs’ stock in HPL through the February 2002 Merger.  For the same reason that the court in Carley denied the Motion to Dismiss, this Court should deny PWC’s Motion for Summary Judgment.

In CMNY Capital, L.P. v. Deloitte & Touche, a group of investors in a corporation which subsequently went bankrupt brought a securities fraud action against the corporation’s accountant.  In denying the accountant’s motion to dismiss the federal securities law claim, the court noted that the numerous accounting failures alleged by the plaintiffs, as well as the accountant’s failure to respond to certain “red flags,” could support a finding of recklessness.  Like the facts of the instant case, in CMNY Capital, there were a large number of transactions for which revenue was recognized at the end of a fiscal year and there was a singly dominated management of the corporation which was unduly aggressive toward financial reporting.  Taking into account these factors, the court stated as follows:

In the present case, Plaintiffs allege numerous accounting failures that, construed favorably to Plaintiffs as they must be on a Fed. R. Civ. P. 12(b)(6) motion, could support an inference of recklessness.  To begin with, certain allegations involve “red flags” of the type that D&T maintains are required before the recklessness standard can be applied:  “[f]ictitious sales were included in the revenues reported in the financial statement,” and “the amount of each of these year-end invoices [was] significantly greater than the usual invoices”; “[e]ven the most cursory review would have revealed a singly dominated management unduly aggressive toward financial reporting which had difficulty retaining high quality senior financial personnel,” and D&T was allegedly aware of “[l]arge and unusual transactions.”  Moreover, Plaintiffs allege numerous departures from ordinary care that, especially when taken together, would permit a finder of fact to infer that Touche acted recklessly.

CMNY Capital, 821 F. Supp. at 166; see also First Merchants Acceptance Corp. Sec. Litig., 1998 WL 781118 at *11 (“Thus, the allegations in the complaint, including the magnitude of the misstatements, the specific GAAP and GAAS violations and the ‘red flags’ together support an inference that Deloitte’s audit ‘amounted to no audit at all or an egregious refusal to see the obvious or investigate the doubtful.’”); In re Smartalk Teleservices, Inc. Sec. Litig., 124 F. Supp. 2d 505, 515 (S.D. Ohio 2000) (“GAAP and GAAS violations are relevant to show an auditor’s scienter when the complaint also identifies specific, highly suspicious facts and circumstances available to the auditor at the time of the audit and alleges that these facts were ignored, either deliberately or recklessly.”).

In Arnlund v. Deloitte & Touche, L.L.P., 199 F. Supp. 2d 461 (E.D. Va. 2002), shareholders of a home furnishings retailer brought actions against its auditor for securities fraud and common law fraud in connection with the retailer’s annual report.  In ruling on the accountant’s motion to dismiss, the court noted that a plaintiff could survive such a motion by pleading facts that gave rise to a “strong inference of simple recklessness.”  Id. at 473.  The court amplified on this standard, stating as follows:

Thus, a plaintiff can satisfy the heightened burden of pleading scienter under the PSLRA by identifying specific facts and circumstances available to the auditor that are unusual, suspicious or that, for other reasons, would put the auditor on notice of matters that ought to be looked into or reported on because, if true, they could alter an auditor’s opinion or foreclose it entirely, and by alleging that these facts were ignored, either deliberately, recklessly, or by failing to follow generally accepted accounting and auditing principles.

Id. at 475; see also Oxford Health Plans, Inc. Sec. Litig., 51 F. Supp. 2d 290, 295 (S.D. N.Y. 1999) (In a federal securities law claim brought against auditor KPMG and involving allegations of improper revenue recognition, the court stated that “An egregious refusal to see the obvious, or to investigate the doubtful, may in some cases give rise to an inference of recklessness.”). Based on the foregoing case law and the facts set forth above, it is clear that Plaintiffs have pled facts more than sufficient to demonstrate PWC’s recklessness.[6] For this reason, the Motion should be denied as to Plaintiffs’ claim for aiding and abetting a violation of the Texas Securities Act.

B.        The evidence clearly establishes that PWC rendered substantial assistance to HPL.

 

The evidence in this case clearly establishes that PWC rendered substantial assistance to HPL.  First, it is unquestioned that PWC audited HPL’s financial statements for the fiscal year ended March 31, 2001, and that such audited financial statements were included in HPL’s IPO Prospectus.  It is also uncontroverted that PWC’s opinion for the 2001 HPL audit was a “clean” or unqualified opinion.  See Scarpelli Depo at pp. 137-138.  Moreover, it is clear that such a clean or unqualified opinion was necessary for HPL’s IPO to go forward.  Id. And Plaintiffs’ expert , Paul Regan, has opined that PWC would have discovered the misrepresentations had it exercised due diligence in its audit.  Exhibit R at pars. 20, 21.

Doug Brown also testified that PWC knew that its audited financials of HPL would be included in the Prospectus for the 2001 IPO and that PWC knew that investors would likely rely on those audited financials in making investment decisions.  Brown Depo at p. 329-30. He also admitted that PWC knew that one of the reasons for HPL’s IPO was to allow it to generate proceeds to acquire other companies.  Id. And Michael Scarpelli testified that the cash generated from HPL’s IPO was the cash that was used to acquire CTG in the cash and stock merger transaction.  See Scarpelli Depo at pp. 130, 294-295.

Under the foregoing circumstances, it is unquestioned that PWC’s unqualified audit opinion of HPL rendered substantial assistance to HPL and its primary violation of the Texas Securities Act.  See, e.g., Nationwide Cellular Service, Inc. v. American Mobile Communications, Nos. 90CIV6493, 91 CIV 3587, 1999 WL 233284 at *9 (S.D.N.Y. Oct. 29, 1991) (In securities fraud case brought by shareholders of acquired corporation against accounting firm BDO, the court stated that the plaintiffs had “met the requirement of showing ‘substantial assistance’ by alleging that the BDO defendants’ certification of the fraudulent financial statements was a substantial factor in inducing the sale of its securities”); Roberts v. Peat, Marwick, Mitchell & Co., 857 F.2d 646, 653 (9th Cir. 1988) (cause of action for aiding and abetting against accountant stated by alleging that “the investors relied on Peat, Marwick’s reputation when deciding to invest and that they would not have invested had Peat, Marwick disclosed the alleged fraud.”); Ponce v. Securities & Exchange Comm’n, 345 F.3d 722, 738 (9th Cir. 2002) (holding that accountant provided substantial assistance to its client’s primary violation of the federal securities laws “by preparing the financial statements that were eventually filed with both the quarterly and annual reports, as well as auditing and certifying the reports” that the client filed); Fine, 919 F.2d at 300 (“The knowing issuance of the materially misleading qualified opinion, we observe, would have substantially assisted Ask, Pardo, or Redding in committing a securities violation.”);  In re Worlds of Wonder Sec. Litig., 721 F.Supp. 1140, 1146 (N.D. Cal. 1989) (in denying motion to dismiss aiding and abetting claim against underwriters and accountant, court held that “[s]ubstantial assistance is sufficiently alleged where plaintiffs claim that they relied on the professional’s reputation when deciding to invest.”).  For this reason, the Motion should be denied.

VI.       The Motion should be denied as to Plaintiffs’ conspiracy claim.

The Motion should be denied as to Plaintiffs’ conspiracy claim.  A civil conspiracy is “a combination of two or more persons to accomplish an unlawful purpose, or to accomplish a lawful purpose by unlawful means ….”  Tilton v. Marshall, 925 S.W.2d 672, 680 (Tex. 1996).  In order to establish a conspiracy, the plaintiff must plead and prove the existence of the following:

(1) two or more persons; (2) an object to be accomplished; (3) a meeting of minds on the object or course of action; (4) one or more unlawful, overt acts; and (5) damages as the proximate result.

Massey v. Armco Steel Co., 652 S.W.2d 932, 934 (Tex. 1983).  Texas courts have consistently held that conspiracies may be proven by circumstantial evidence.  As one court has stated, Abecause of the secretive nature of conspiracies, courts allow a  plaintiff to show conspiracy by circumstantial rather than direct evidence.@  Bernstein v. Portland Savings & Loan Ass=n, 850 S.W.2d 694, 705 (Tex. App. B Corpus Christi 1993, writ denied); Chevalier v. Animal Rehabilitation Center, Inc., 839 F. Supp. 1224, 1230 (N.D. Tex. 1993) (AA civil conspiracy need not be shown by direct evidence and is ordinarily established by circumstantial evidence@).  Consistent with this relaxed standard of proof, courts have held that an agreement between the conspirators, one of the predicates of a conspiracy, Aneed not be formal, the understanding may be tacit, and each conspirator need not know the details of the conspiracy.@  Bernstein, 850 S.W.2d at 705.

Many courts have also noted that a conspiracy claim may be proven by reasonable inferences since conspirators are unlikely to formalize their agreements.  For example, the Texas Supreme Court has stated that Athe general rule is that conspiracy liability is sufficiently established by proof showing concerted action or other facts and circumstances from which the natural inference arises that the unlawful, overt acts were committed in furtherance of common design, intention, or purpose of the alleged conspirators.@  International Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567, 581 (Tex. 1963).  In addition to the meeting of the minds element, the Acommon purpose@ element of a  conspiracy may also be established by reasonable inferences:

When men enter into conspiracies, they are not likely to call in a witness ….  In such cases, the injured party must necessarily have recourse to circumstantial evidence.  For it is only by the inferences and deductions which men properly and naturally draw from the acts of others in such cases, that their intentions can be ascertained.  They are not likely to proclaim them in the hearing of witnesses.

Carroll v. Timmers Chevrolet, Inc., 592 S.W.2d 922, 926 (Tex. 1979).

Under the foregoing standards, the uncontroverted facts of the instant case raise a genuine issue of material fact regarding the existence of a meeting of the minds between PWC and HPL.  For example, the evidence shows a disturbing pattern whereby PWC took directions from and obtained information from David Lepejian to the exclusion of others at HPL, including its board of directors.  Doug Brown testified that the primary people he interacted with at HPL regarding revenue recognition were David Lepejian and Ita Geva (Brown Depo. at p. 43), that he relied on Lepejian and Geva to inform him whether services were essential to the functionality of HPL’s software (Brown Depo. at pp. 244-45), and that he relied on Lepejian and Geva to explain the installation and customization necessary with PWC’s software (Brown Depo. at pp. 250, 316-18).  Similarly, audit partner Michael Scarpelli relied solely on Lepejian to explain Canon’s failure to provide purchase orders from its end-users, a critical failure under the revenue recognition rules set forth in SOP 97-2.  Scarpelli Depo. at pp. 171-72.  He also relied on information from Lepejian to determine whether software installation was HPL’s or Canon’s responsibility. Id. at p. 186.   This reliance is particularly disturbing given the fact that PWC’s own documents warned that Lepejian dominated HPL, controlled revenue recognition and had the ability to override decisions made by anyone else at HPL.  Brown Depo. at pp. 74-77, 81-83.

Equally probative are the numerous examples of PWC watering down the criticisms in its draft letter to HPL’s management to delete specific criticisms and concerns regarding David Lepejian.  For example, PWC’s draft management recommendation letter to HPL’s Board of Directors noted that David Lepejian had the ability to override all decisions and to control revenue recognition, but that observation was omitted in the final version of the management recommendation letter it presented to HPL’s Board.  Brown Depo at pp. 85-87.  And PWC’s recommendations regarding HPL’s CFO and Audit Committee were also omitted from the final report.  Brown Depo. at pp. 85-92.

Overlaying this evidence is the fact that PWC audit partner Michael Scarpelli accepted a job with HPL in December 2001, before the merger between HPL and CTG.  Scarpelli Depo. at pp. 114-16.  Among the elements of his generous compensation package was a $750,000 “loan” forgivable over 5 years and over 300,000 HPL stock options.  Scarpelli Depo. at pp. 120-21, 126-27.  The foregoing evidence supports the existence of a conspiracy between PWC and HPL and mandates denial of its Motion.

CONCLUSION AND PRAYER

WHEREFORE, PREMISES CONSIDERED, Plaintiffs pray that the Court deny Defendant PricewaterhouseCoopers L.L.P.’s Motion for Summary Judgment and award Plaintiffs  such other and further relief to which they are justly entitled.

Respectfully submitted,
HEYGOOD, ORR & PEARSON
2331 W. Northwest Highway
Second Floor
Dallas, Texas 75220
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[1]While no Texas courts have applied this specific provision of Section 552, numerous courts have adopted Section 552 in its entirety as setting forth the law on negligent misrepresentation.  See, e.g., Shatterproof Glass, 466 S.W.2d at 878-879 (specifically mentioning the “public duty” provision in § 552(3) and stating that §552 “should be adopted in Texas for application to cases of this nature.”); Cook Consultants, 700 S.W.2d at 234-35 (affirming adoption of §552); Federal Land Bank Ass’n of Tyler v. Sloan, 825 S.W.2d 439, 442 (Tex. 1991) (agreeing with §552’s definition of negligent misrepresentation); Steiner, 734 F. Supp. at 279 (“Texas courts follow §552 of the Restatement (Second) of Torts in imposing liability for negligent misrepresentations.”); McCamish, 991 S.W.2d at 791 (“This Court has already adopted the tort of negligent misrepresentation as described by the Restatement (Second) of Torts §552.”).

[2] Although some of the Plaintiffs may have only skimmed the Prospectus and other documents and other Plaintiffs may have relied in part on the recommendations of Mark Harward and others, neither of these facts negate reliance.  See, e.g., Eisenberg v. Gagnon, 766 F.2d 770, 779 (3d Cir. 1985) (In reversing trial court’s grant of JNOV on negligent misrepresentation claim based on misleading offering memoranda, court stated that  although “plaintiffs’ reading of the documents was less than exacting, plaintiffs’ testimony presented sufficient evidence to raise a jury question on the issue of reliance.  Plaintiffs need not prove that they read the materials in their entirety, or that the recommendation of an agent or adviser did not play a part in their investment decisions.”).

[3] While the claims of Mr. Stoner, Mrs. Harward, Mrs. Tigelaar, Mrs. Schibler and Mrs. Lane should not be dismissed, the Court should note that dismissal of these claims will not impact Plaintiffs’ ability to recover their full damages herein. The shares in CTG owned by these five plaintiffs were clearly under the sole management and control of their spouses.  In fact, the stock certificates representing the shares in CTG exchanged for shares in HPL were originally issued solely in the names of Brenda Stoner and Messrs. Harward, Tigelaar, Schibler and Lane.  Under Texas law, these shares were under their sole management and control and any claims for damages incurred as a result of their disposition may be brought solely in the names of these Plaintiffs.  See Tex. Fam. Code §§3.102, 3.104 (Vernon 2003); Jean v. Tyson-Jean, 118 S.W.3d 1 (Tex. App. – Houston [14th Dist.] 2003, no pet.); Medenco, Inc. v. Myklebust, 615 S.W.2d 187 (Tex. 1981); Cummings v. Johnson, 616 F.2d 1069 (9th Cir. 1979).

[4] The Texas Supreme Court has explicitly endorsed Section 531’s reason-to-expect standard as consistent with Texas fraud jurisprudence.  Ernst & Young, 51 S.W.3d at 580.

[5] Although “general awareness” is not the proper test, Plaintiffs submit that this evidence satisfies both the applicable recklessness standard and the general awareness standard advocated by PWC.

[6]While “general awareness” is not the test, Plaintiffs submit that the evidence set forth above in Sections III.C and V.A(2) demonstrate PWC’s general awareness or, at a minimum, raise a genuine issue of material fact in this regard.