Hufnagle v. Rino International Corp.: Plaintiff Adequately Pleads Scienter in Claim for Securities Fraud against Company's Auditor

In Hufnagle v. Rino Int’l Corp., CV 10-08695, 2013 WL 3976833 (C.D. Cal. Aug. 1, 2013), the United States District Court for the Central District of California denied defendant Frazer Frost, LLP’s ("Defendant") motion to dismiss plaintiff’s Third Amended Complaint ("Complaint") and held that Susan Hufnagle, individually and on behalf of those similarly situated(collectively “Plaintiff”), properly alleged scienter under Section 10(b) of the Securities Exchange Act of 1934 (“§ 10(b)”).

In the original Complaint, Plaintiff alleged that Rino International Corporation ("Rino"), Rino’s management, and Defendant--who is Rino’s auditor--conducted widespread fraud regarding Rino's Chinese industrial equipment business. The allegations include overstating revenue and profits, understating tax liability, and concealing transactions between Rino and companies managed by Rino’s CEO’s relatives. After filing the Complaint, Plaintiff entered into a settlement agreements with all defendants except Defendant.

In the Complaint, Plaintiff alleged that Defendant knowingly or recklessly ignored financial irregularities, failed to follow generally accepted auditing standards when he reviewed Rino’s financial statements, and issued false opinions concerning Rino’s financial statements.

In order to adequately plead a securities fraud claim under § 10(b) and Rule 10b-5, a plaintiff must allege facts that show (1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss. Cases brought under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), like Plaintiff's, must also meet the PSLRA’s heightened pleading standard, which requires a complaint to state with particularity facts giving rise to a strong inference that the defendant acted with scienter. If particular facts, when viewed individually, do not support a strong inference of scienter, a court must conduct a holistic review of the allegations. When viewed holistically, individually insufficient allegations can support a strong inference of scienter.

Defendant’s motion to dismiss specifically challenged whether Plaintiff had adequately plead scienter.

Plaintiff argued the court should draw a strong inference of scienter from the fact Defendant had actual knowledge that Rino kept two sets of corporate books, one of which provided inflated revenues and profits to investors, and Defendant informed Rino’s management of significant deficiencies in Rino’s internal financial controls.

The court found the alleged facts gave rise to what it described as both "innocent" and "malicious" inferences. Because the facts alleged allowed for both malicious and innocent inferences, the court determined the allegations alone did not support a strong inference of scienter.

Next, the court analyzed the allegations that Defendant instructed Rino to use an accounting technique that violated generally accepted accounting principles and Defendant failed to check the status of the customers and contracts that were used to determine Rino’s future revenue. The court found the alleged practices did not violate accounting standards, and thus the allegations did not support a strong inference of scienter.

The court determined the facts, viewed individually, were insufficient to establish a strong inference of scienter. It found, however, that holistically the first two allegations, alongside the allegations Defendant knew that Rino advanced more than $34 million to suppliers that were owned by the CEO’s relatives and Rino issued its CEO an interest-free, unsecured loan of $3.5 million to purchase a personal residence more readily supported the inference of wrongdoing. Thus, the court found Plaintiff's allegations holistically supported an inference of scienter.

Accordingly, the court denied the Defendant’s motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.

Riley Combelic