Partial Dismissal of Zst

8/2/2019 Partial Dismissal of Zst

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UNITED STATES DISTRICT COURTCENTRAL DISTRICT OF CALIFORNIA

CIVIL MINUTES - GENERAL

Case No. CV 11-03531 GAF (JCx) Date February 14, 2012

Title Robert Scott v. ZST Digital Networks, Inc. et al.

CV-90 (06/04) CIVIL MINUTES - GENERAL Page 1 of 19

Present: The Honorable GARY ALLEN FEESS

Renee Fisher None N/A

Deputy Clerk Court Reporter / Recorder Tape No.

Attorneys Present for Plaintiff : Attorneys Present for Defendants:None None

Proceedings: (In Chambers)

ORDER RE: MOTIONS TO DISMISS

I. INTRODUCTION

ZST Digital Networks, Inc., (ZST) is a Delaware corporation with its principal place ofbusiness in Henan Province, Peoples Republic of China (PRC) where its business operationsinclude the development of digital and optical networking equipment supplied to local cableoperators. ZST reports its annual financial results to both the SEC and to a PRC governmentalagency, the State Administration of Industry and Commerce (SAIC). According to Plaintiffs,ZST reported financial results to the SEC indicating revenues over $50,000,000 in 2008 and over$100,000,000 in 2009, while reporting to the SAIC results that were a minuscule fraction ofthose figures. In this action, Plaintiff contends that the financial data submitted to the SEC wasfalse and that ZSTs submissions violated numerous federal securities laws.

Defendants now move to dismiss the complaint on the grounds that it fails to meet therequisite standard of particularity, and that the Lead Plaintiff lacks standing to assert claimsunder the Securities Act. For the reasons set forth below, the Court finds that the Exchange Actclaims are adequately pleaded, but that Plaintiff has not properly alleged standing under theSecurities Act. Accordingly, the motions are GRANTED in part and DENIED in part.

II. BACKGROUND

The action is brought on behalf of all persons who either [1] purchased or otherwiseacquired ZST securities pursuant or traceable to the Companys Registration Statement issued in

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connection with its October 20, 2009 initial public offering of securities (IPO); or [2]purchased or otherwise acquired ZST securities from October 20, 2009 through April 21, 2011(the Class Period), except for certain excluded persons and entities. (Docket No. 43,Consolidated Class Action Compl. (Compl.) at 1.) The complaint alleges that Defendantsviolated Sections 11 and 15 of the Securities Act of 1933 (the Securities Act) and Sections10(b) and 20(a) of the Securities Exchange Act of 1934 (the Exchange Act) by submitting tothe Securities and Exchange Commission (SEC) financial reports that were materially false

and misleading, and which omitted facts to conceal adverse material information about thebusiness operations and future prospects of ZST . . . . (Id. 52)

In deciding a motion to dismiss, the Court must accept all well-pleaded factual allegationsin the complaint as true. Blake v. Dierdorff, 856 F.2d 1365, 1368 (9th Cir. 1988).

During the Class Period ZST maintained two materially different sets of financial records,one for reporting financial results in China to the SAIC, and another for reporting financialresults in the United States to the SEC. (Id. 1.) Because financial reports submitted to theSAIC, unlike those filed with the SEC, are not publicly available, the discrepancies between thetwo sets of records was not known to the investing public until April 21, 2011, when that factwas disclosed via a two-part Internet report entitled ZST Digital Networks Unfolded: A MutualFund Manager Seeks the Truth. (Id. 2, 49.) The report disclosed that ZST had reportedrevenue of over $55 million to the SEC in 2008, and revenue of only $20,000 to the SAIC forthe same fiscal year, and that the Company had reported losses of $130,000 to the SAIC, ratherthan the $6 million profit reported to the SEC. (Id. 4.) ZSTs per share stock priceimmediately dropped from $4.36, the closing price on the day prior, April 20, to $2.68, theclosing price on April 21. (Id. 5.)

The disclosure of this information revealed that ZSTs Registration Statement, filed withthe SEC in connection with the IPO, contained materially different financial reporting than

statements filed by the Companys wholly-owned subsidiary, Zhengzhou ZST, to Chinas SAIC.(Id. 38-44.) According to Plaintiff, ZSTs annual SAIC reports were audited by Chinesecertified accountants, and contained lengthy audit opinions verifying the veracity of thereports. (Id. 45.) Although one unaffiliated with the company must submit requests to theSAIC and pay certain fees to obtain such reports, Plaintiff alleges that they are readilyavailable to a companys authorized agents, such as its auditors or underwriters. (Id. 48.)

The complaint asserts that: [1] if ZSTs SEC reports were materially inaccurate, variousdefendants are liable under both the Securities Act and the Exchange Act for the materialmisstatements contained therein; [2] if ZSTs SAIC reports were inaccurate, various defendants



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are liable under the Securities Act for representing in the Registration Statement that its Chinesesubsidiary had been and would continue to faithfully comply with all Chinese laws, and/orfailing to disclose in the Registration Statement that the Company was submitting contradictoryfinancial reports to the SAIC. (Id. 6, 56-57.)

Plaintiff asserts four causes of action, under Sections 11 and 15 of the Securities Act, andSections 10(b) and 20(a) of the Exchange Act. Plaintiff names a number of defendants,

including ZST (the Issuer Defendant); several of the Companys executives and officers (theIndividual Defendants), who allegedly signed various SEC filings containing themisstatements and/or omissions; Rodman and Renshaw, LLC and WestPark Capital, Inc., twoinvestment banks which served as underwriters for the Companys IPO (the UnderwriterDefendants); and the Companys outside accountant, Kempisty & Company, P.C., whichaudited the financial statements submitted to the SEC (Kempisty or the Auditor Defendant).(Id. 12-27.)

Despite the Courts obligation to accept the truth of the facts asserted in the complaint,Defendants seek to blunt the force of the allegations by presenting evidence in support of thepending motions. Specifically, Defendants attach the Companys amendment to its 2010 10-K,which addresses to some extent the discrepancies between the SEC and SAIC reports, as well asthe ongoing risks posed by the inaccuracies contained in the SAIC reports:

Our annual inspection reports filed with the SAIC for our PRC operating

subsidiary, Zhengzhou ZST, have not been in compliance with applicable PRC

regulations, and this could subject us to fines, penalties, and/or revocation of our

business license.

As one of its primary functions, the PRC State Administration of Industry andCommerce, or SAIC, and its local branches are responsible for the annual inspection

of the business licenses of PRC domestic companies and foreign invested enterprisesestablished in China. In connection with its annual inspection, the SAIC or its localbranch, as applicable, requires these companies to file an annual inspection report andto submit financial statements as supplemental documentation.. . .

The Enterprises Annual Inspection Regulations in the PRC stipulate that the SAIC's orits local branch's focus in its review of these financial reports shall be on payment andauthenticity of a company's registered capital, as a primary factor of such company'slegal existence and good standing. As a result, the filing of these financial reports with



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the SAIC is often viewed generally as an administrative function.

The reports that we filed with the SAIC for Zhengzhou ZST for fiscal 2008 and 2009contained financial information that is materially different from the financialstatements in our SEC filings. In addition, Zhengzhou ZST was converted from adomestic company to a foreign-invested company in 2008; however, the local AIC didnot require Zhengzhou ZST to provide audited reports when it conducted its annual

inspections for 2010, 2009 and 2008. As such, our SAIC reports for 2010, 2009 and2008 do not comply with the requirements under Notice 33.

According to our PRC counsel, the relevant laws do not provide for consequences offailure to provide audited report in an annual inspection which a company has passed;however, it is required that the information provided in the annual inspection report begenuine and accurate. In the event a company has false statements or omissions in itsreports, such company may be required to revise these reports to provide accurateinformation and may be subject to fines from RMB10,000 to RMB50,000(approximately US$1,600 to US$7,800) per filed SAIC report; if the discrepancies arematerial, in some instances the company's business license may be revoked.

Following the filing of the 2009 SAIC report, the Company enhanced the proceduresit follows with regard to SAIC financial report filings, so that there would be nomaterial differences with the financial statements filed with the SEC. We do notbelieve that the financial information contained in our 2010 SAIC report is materiallydifferent from the financial information contained in our audited SEC filings, and wedo not anticipate that the financial information reported under both regulatoryschemes will be materially different in the future. We believe that the likelihood ofimposition of a penalty in connection with the 2010, 2009 and 2008 financial reportsfiled with the SAIC is low and, even if imposed, would be deemed immaterial.

However, we cannot assure you that we will not be penalized or have our licenserevoked for not complying with Notice 33. If the local AIC takes any legal actionagainst us for our non-compliance with such regulation, our financial conditions andresults of operations may be adversely and materially affected.

We and an increasing number of China-based companies listed on U.S. stock

exchanges have become the subject of negative media reports that focus on

differences between the financial information set forth in filings with the US SEC

and filings with the PRC's SAIC. The financial information contained in our

SAIC reports for fiscal 2008 and 2009 were materially different than our SEC



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filings, and we have, and may continue to be, subject to these types of negative

reports, which have and may continue to adversely affect the price of our

common stock.

During the second half of 2010 and continuing into 2011, numerous media reports inthe United States and elsewhere made negative claims or suggestions regardingChina-based companies listed on U.S. stock exchanges, including claims and

suggestions relating to the accuracy and completeness of such companies' financialinformation filed with the U.S. SEC. Many of these reports appear to have been based,at least in part, on differences between financial information set forth in a company'sfilings with the U.S. SEC and filings with the PRC's State Administration for Industryand Commerce (SAIC).

As noted above, the SAIC reports for Zhengzhou ZST for fiscal 2009 and 2008contained financial information that was materially different from the financialstatements in our SEC filings. In connection with these material differences, we havebeen subject to these negative reports that have focused on such material differences,accompanied by allegations of fraud. We do not believe that the financial informationcontained in our 2010 SAIC report is materially different from the financialinformation contained in our audited SEC filings and we do not anticipate that thefinancial information reported under both regulatory schemes will be materiallydifferent in the future; however, we remain subject to additional negative mediareports by short sellers or media who may publish negative claims or suggestionsabout us or our financial results, including claims focused on any differences betweenthe financial information we disclose in our SAIC and SEC filings, which couldnegatively affect the price of our common stock.

(Docket No. 58, Declaration of Stephen D. Hibbard (Hibbard Decl.), Ex. J [Amended 2010

10-K] at 9-10).

Based on these facts among others, Defendants filed three separate motions to dismiss.(Defendant Kempisty (Docket No. 48, Kempisty-Mem.); the Underwriter Defendants (DocketNo. 53, UW-Mem.); Defendant ZST (Docket No. 57, ZST-Mem.)). Plaintiff sought leave to file,and did file an omnibus opposition to the motions. (Docket No. 78, Opp.)

The Court separately addresses the Exchange Act and Securities Act claims. Because itconcludes that the discrepancies between the two public filings constitute sufficient pleading ofboth falsity and scienter, and that the issue of which set of reports is accurate is not properly



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resolved on a motion to dismiss, the Court DENIES the motions insofar as they are directed atthe Exchange Act claims. However, the Court finds that Plaintiff has not properly establishedhis standing to bring Securities Act claims, and therefore GRANTS the motions to the extentthat they urge dismissal of the complaints first and second causes of action.

III. DISCUSSION

A. PLEADING STANDARDS UNDER FEDERAL RULES OF CIVIL PROCEDURE 12(B)(6) AND 9(B),AND THE PSLRA

A complaint may be dismissed if it fails to state a claim upon which relief can be granted.See Fed. R. Civ. P. 12(b)(6). On a motion to dismiss under Rule 12(b)(6), a court must accept astrue all factual allegations pleaded in the complaint, and construe them in the light mostfavorable to the nonmoving party. Cahill v. Liberty Mut. Ins. Co., 80 F.3d 336, 33738 (9thCir. 1996) Dismissal under Federal Rule of Civil Procedure 12(b)(6) may be based on either (1)a lack of a cognizable legal theory, or (2) insufficient facts under a cognizable legal theory.SmileCare Dental Grp. v. Delta Dental Plan of Cal., Inc., 88 F.3d 780, 783 (9th Cir. 1996)(citing Robertson v. Dean Witter Reynolds, Inc., 749 F.2d 530, 534 (9th Cir. 1984)).

Under Federal Rule of Civil Procedure 8(a)(2), a complaint must contain a short andplain statement of the claim showing that the pleader is entitled to relief. Fed. R. Civ. P.8(a)(2). The Supreme Court has interpreted this rule to allow a complaint to survive a motion todismiss only if it contain[s] sufficient factual matter, accepted as true, to state a claim to reliefthat is plausible on its face. Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949 (2009) (quoting Bell Atl.Corp. v. Twombly, 550 U.S. 544, 570 (2007)). A claim has facial plausibility when theplaintiff pleads factual content that allows the court to draw the reasonable inference that thedefendant is liable for the misconduct alleged. Id. (citing Twombly, 550 U.S. at 556).[W]here the well-pleaded facts do not permit the court to infer more than the mere possibility ofmisconduct, the complaint has not sufficiently established that the pleader is entitled to relief.Id. at 1950.

While a complaint generally need not contain detailed factual allegations, a plaintiffsobligation to provide the grounds of his entitlement to relief requires more than labels andconclusions, and a formulaic recitation of the elements of a cause of action will not do.Twombly, 550 U.S. at 555 (citation, alteration, and internal quotation marks omitted). Similarly,a court need not accept as true allegations that are merely conclusory, unwarranted deductionsof fact, or unreasonable inferences. Sprewell v. Golden State Warriors, 266 F.3d 979, 988 (9thCir. 2001). In other words, the tenet that a court must accept as true all of the allegations



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contained in a complaint is inapplicable to legal conclusions. . . . While legal conclusions canprovide the framework of a complaint, they must be supported by factual allegations. Iqbal,129 S. Ct. at 194950.

Moreover, Federal Rule of Civil Procedure 9(b) imposes heightened pleadingrequirements for claims of fraud. See Fed. R. Civ. P. 9(b). Under Rule 9(b), a plaintiff muststate with particularity the circumstances constituting fraud, but can allege generally [m]alice,

intent, knowledge, and other conditions of a persons mind. Id. The particularity requirementhas been interpreted to mean the pleader must state the time, place and specific content of thefalse representations as well as the identities of the parties to the misrepresentation.Miscellaneous Serv. Workers, Drivers & Helpers, Teamsters Local No. 427 v. Philco-FordCorp., 661 F.2d 776, 782 (9th Cir. 1981). Further, where there are multiple defendants, Rule9(b) does not allow a complaint to . . . lump multiple defendants together but require[s] plaintiffsto differentiate their allegations when suing more than one defendant. Destfino v. Reiswig, 630F.3d 952, 958 (9th Cir. 2011) (citation and internal quotation marks omitted). In addition, theplaintiff must set forth what is false or misleading about a statement, and why it is false.Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156, 1161 (9th Cir. 2009) (internal quotationsomitted). These requirements ensure . . . that allegations of fraud are specific enough to givedefendants notice of the particular misconduct which is alleged to constitute the fraud charged sothat they can defend against the charge and not just deny that they have done anything wrong.Semegen v. Weidner, 780 F.2d 727, 731 (9th Cir. 1985).

Beyond the requirements of Fed. R. Civ. P. 12(b)(6) and 9(b), the PSLRA establisheseven higher pleading standards a plaintiff must meet when alleging a securities fraud cause ofaction. These requirements pertain largely to the scienter and falsity inquiries, which theCourt addresses below.

B. EXCHANGE ACT CLAIMS

The bulk of the parties argument centers on Plaintiffs first and third causes of action,under Section 11 of the Securities Act and Section 10(b) of the Exchange Act, respectively.Plaintiffs second and fourth causes of action, under Section 15 of the Securities Act and Section20(a) of the Exchange Act, are both control claims, which are largely derivative of and dependon primary violations of the respective Acts. The Court first addresses the Exchange Act claims,and then turns to Plaintiffs Securities Act claims.

Plaintiffs third cause of action alleges that Defendants ZST and Kempisty violatedSection 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder. (Compl.



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117128.) Plaintiff alleges that during the Class Period, Defendants carried out a plan, scheme,and course of conduct which was intended to and, through the Class Period, did: [1] deceive theinvesting public, including Lead Plaintiff and other Class members . . . ; and [2] caused LeadPlaintiff and other members of the Class to purchase ZST securities at artificially inflatedprices. (Id. 119.) Moreover, Plaintiff alleges that Kempisty, in furtherance of that fraudulentscheme, audited and approved ZSTs financial statements despite knowing or deliberatelydisregarding the fact that they were materially false and misleading. (Id. 120.)

The complaint alleges that the Defendants made untrue statements of material fact oromitted to state material facts necessary to make the statements not misleading, despite havingpossession of material adverse non-public information which contradicted those statements andpublic information about the business, operations, and future prospects of ZST . . . . (Id. 121122.) Unlike the claims brought under the Securities Act, Plaintiff relies solely on his firsttheory of liability in pleading his Section 10(b) claim, namely that ZSTs financial reportssubmitted to the SEC were materially inaccurate, and that Defendants are therefore liable formaterially misstating the financial information contained therein. (Id. 6.) Plaintiff and othermembers of the Class, according to the complaint, were ignorant of the fact that market prices ofZSTs publicly traded securities were artificially inflated, and relied directly and/or indirectly onthe false and misleading statements made by Defendants, or upon the integrity of the market inwhich ZSTs stock trades. (Id. 125.) As a direct and proximate result of that conduct,Plaintiff alleges that he and other members of the Class suffered damages in connection withtheir purchase of the Companys securities.

To state a claim under Section 10(b) of the Exchange Act, a plaintiff must allege andadequately plead (1) a material misstatement or omission; (2) scienter; (3) connection with thepurchase or sale of a security; (4) reliance; (5) proximate or loss causation; and (6) economicloss. Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 341 (2005). Defendants contend thatPlaintiff has failed to adequately plead the first, second, fourth, and fifth such elements.

1. SCIENTER AND FALSITY

To demonstrate scienter, the PSLRA requires that a plaintiff state with particularity factsgiving rise to a strong inference that the defendant acted with the required state of mind inmaking misleading statements and/or omissions. 15 U.S.C. 78u-4(b)(2). Under thisprovision, the mental state required for securities fraud liability is distinct from the level ofpleading required to infer that mental state. South Ferry LP, No. 2 v. Killinger, 542 F.3d 776,782 (9th Cir. 2008) (quoting In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970, 975(9th Cir. 1999)). A plaintiff must show that the defendant engaged in knowing or



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intentional conduct. South Ferry, 542 F.3d at 782. In the Ninth Circuit, reckless conductcan almost meet this standard to the extent that it reflects some degree of intentional orconscious misconduct, or what [courts] have called deliberate recklessness. Id. (citing SiliconGraphics, 182 F.3d at 977) (quotation marks omitted). Thus, in sum, a complaint must state withparticularity facts giving rise to a strong inference of deliberate recklessness in order to satisfythe PSLRAs pleading requirements for scienter.

The Supreme Court has held that this strong inference must be cogent and compelling,[and] thus strong in light of other explanations. Tellabs, Inc. v. Makor Issues and Rights, Ltd.,551 U.S. 308, 324 (2007). The reviewing court must ask, when the allegations are accepted astrue and taken collectively, would a reasonable person deem the inference of scienter a least asstrong as any opposing inference? Id. at 326. In other words, [a] court must compare themalicious and innocent inferences cognizable from the facts pled in the complaint, and onlyallow the complaint to survive a motion to dismiss if the malicious inference is at least ascompellingas any opposing innocent inference. Zucco Partners, LLC v. Digimarc Corp., 552F.3d 981, 991 (9th Cir. 2009). The court must determine whether all of the facts alleged, takencollectively, give rise to a strong inference of scienter, not whether any individual allegation,scrutinized in isolation, meets that standard. Id. (quoting Tellabs, 551 U.S. at 323); see alsoSouth Ferry, 542 F.3d at 784 (The Supreme Court's reasoning in Tellabs permits a series of lessprecise allegations to be read together to meet the PSLRA requirement.)

Moreover, with respect to falsity, the complaint must specify each statement alleged tohave been misleading, the reason or reasons why the statement is misleading, and, if anallegation regarding the statement or omission is made on information and belief, the complaintshall state with particularity all facts on which that belief is formed. 15 U.S.C. 78u-4(b)(1).

The scienter and falsity inquiries overlap significantly. In Ronconi v. Larkin, the NinthCircuit explained that:

Because falsity and scienter in private securities fraud cases are generally stronglyinferred from the same set of facts, we have incorporated the dual pleadingrequirements of 15 U.S.C. 78u-4(b)(1) and (b)(2) into a single inquiry. Inconsidering whether a private securities fraud complaint can survive dismissal underRule 12(b)(6), we must determine whether particular facts in the complaint, taken asa whole, raise a strong inference that defendants intentionally or with deliberaterecklessness' made false or misleading statements to investors.

253 F.3d 423, 429 (9th Cir. 2001) (quoting Silicon Graphics, 183 F.3d at 979). The Ninth



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Circuit recently re-iterated that falsity may itself be indicative of scienter where it is combinedwith allegations regarding a management's role in the company that are particular and suggestthat the defendant had actual access to the disputed information, and where the nature of therelevant fact is of such prominence that it would be absurd to suggest that management waswithout knowledge of the matter. Zucco Partners, 552 F.3d 981 at 1000 (quotation marks andcitation omitted) (quoting South Ferry, 542 F.3d at 785).

a. Representations in SEC Reports

As ZST notes in its motion, Plaintiff premises his first theory of liability solely on thediscrepancies between the Companys 2008 and 2009 SAIC and SEC filings. (ZST-Mem. at12.) It is true, as Defendants repeatedly point out, that the complaint contains no particularizedallegations supporting the notion that it was the SEC filings, as opposed to the SAIC filings,which misstated the companys financial information, nor any company-specific factsconcerning ZSTs sales or accounting practices. Nevertheless, the Court finds that the markeddisparity between the revenue figures reported to American and Chinese regulatory bodies,along with the Companys subsequent and ambiguous explanation of those discrepancies, thestrong inference that the Chinese statement reflected an overstatement in revenues reported tothe SEC are sufficient to constitute falsity and scienter under the PSLRA. The Court thereforefinds that Plaintiff has adequately pleaded a strong inference of scienter based on the allegedfalsity of the revenue figures provided in the SEC reports.

Defendants articulation of an alternative reading of the facts pleaded in the complaint,namely the explanation offered in the Companys amended 10-K and in its briefing, isapparently an effort, through evidence outside the pleadings, to bring this case within theSupreme Courts Tellabs inquiry. Even taking that evidence into consideration, the Court is notpersuaded that the Exchange Act claims should be dismissed. As noted above, the Tellabsinquiry entails a compar[ison] [of] the malicious and innocent inferences cognizable from the

facts pled in the complaint, under which the complaint survives a 12(b)(6) motion only if areasonable person [would] deem the inference of scienter at least as strong as any opposinginference. Zucco, 552 F.3d at 991; Tellabs, 551 U.S. at 326.

On the basis of the record before it, the Court cannot conclude that Defendants readingof the facts is any more compelling than that which is drawn by Plaintiffs allegations. TheCompanys reported revenue to the SEC and to the SAIC differ by a factor of over two thousand,and the Companys reported profit of $6 million to American regulatory authorities is entirelyinconsistent with its report of a loss in China. Although ZST sought to explain thesediscrepancies in its amended 2010 10-K, the proffered explanation merely dances around the

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1 Similarly, it would be difficult to conclude that the alleged misstatements were not material, as theycertainly would have been viewed by the reasonable investor as having significantly altered the total mix ofinformation available. Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1318 (2011).CV-90 (06/04) CIVIL MINUTES - GENERAL Page 11 of 19

issue, noting the existence of a discrepancy without explaining how the company came to reportsuch dramatically different results to the two different governmental agencies. Rather, theamended 10-K merely states that, because the reports are related to the companys legalexistence and good standing, they are viewed generally as an administrative function, andbecause the local administrative body did not require audited reports, the Companyssubmissions did not comply with Chinese regulations. (Hibbard Decl., Ex. J [Amended 201010-K] at 9-10.) That explanation does not even begin to rebut Plaintiffs allegation that the SEC

reports were false, as even if the reports were merely administrative, and even if they were notaudited, the vast divergence between the numbers are not explained by a lack of outside reviewor even a haphazard preparation. As Plaintiff notes, one set of numbers showed a highlysuccessful and profitable company; the other showed a poorly performing company strugglingto make a profit. (Opp. at 1.)

Moreover, Plaintiff avers in his complaint that the Chinese reports were indeed audited,which amounts to an allegation that ZST made misstatements not only in its original filings, butalso in its amended filings intended to correct the prior inaccuracies. (Compl. 45.) In short,Defendants have done nothing other than cite to an ambiguous explanation offered in theCompanys amended 10-K, one which Plaintiff alleges not only fails to correct priormisstatements, but also makes additional false representations. That alone cannot insulate ZSTfrom liability, nor is it sufficient to dismiss a complaint alleging that previously filed reportscontained blatant and fraudulent misrepresentations of the Companys financial health.1

Other courts addressing this very issue have reached the same conclusion. See, e.g., In reChina Education Alliance, Inc. Securities Litigation, No. 10:09239-CAS, Docket No. 61 (C.D.Cal. Oct. 11, 2011) (sustaining similar claims based on allegations that defendant ha[d] filedsignificantly disparate revenue figures in China and the United States, and that companyengaged in other suspicious behavior); Katz v. China Century Dragon Media, Inc. et al., 2011WL 6047093, at *4 (C.D. Cal. Nov. 30, 2011) (holding that, with respect to falsity, a plaintiff

must plead not only that revenue numbers contained in SEC and SAIC reports differed, but alsothat Chinese and American accounting standards are sufficiently similar such that the . . .numbers should be substantially the same . . . .) As noted above, Plaintiff has alleged both thatDefendants filed disparate revenue figures in China and the United States, and that the Company




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2

Defendants contend that the signing of the Registration Statement and certification of Sarbanes-Oxleydocumentation does not itself demonstrate scienter. Until recently, the Ninth Circuit adhered to a general rulefinding inadequate complaints alleging that facts critical to a business's core operations or an importanttransaction generally are so apparent that their knowledge may be attributed to the company and its key officers.Zucco, 552 F.3d at 1000. In South Ferry, however, the Court of Appeals explained that such allegations are onlyone factor in a Tellabs inquiry:

In summary, allegations regarding management's role in a company may be relevant and help tosatisfy the PSLRA scienter requirement in three circumstances. First, the allegations may be used inany form along with other allegations that, when read together, raise an inference of scienter that iscogent and compelling, thus strong in light of other explanations. Tellabs. This view takes suchallegations into account when evaluating all circumstances together. Second, such allegations may

independently satisfy the PSLRA where they are particular and suggest that defendants had actualaccess to the disputed information, as in Daou and Oracle. Finally, such allegations may conceivablysatisfy the PSLRA standard in a more bare form, without accompanying particularized allegations, inrare circumstances where the nature of the relevant fact is of such prominence that it would beabsurd to suggest that management was without knowledge of the matter.

542 F.3d at 785-786. To the extent that such allegations are relevant to the Tellabs inquiry, the Court finds thatthe Individual Defendants signatures certifying the Companys financial statements, along with the criticalimportance of the financial information being certified, support a finding of scienter. See, e.g., In re MedicisPharmaceutical Corp. Securities Litigation, 2010 WL 3154863, at *5 (D. Ariz. 2010) (Accounting errors thatprove to have a significant impact on core business operations, i.e. cash, revenue, profits, liquidity, or viability ofa product, sometimes give rise to a compelling inference of scienter. This is so because such substantial errors

give rise to an inference that the defendant acted recklessly or intentionally used deceptive accounting principlesto disguise serious problems.) (internal citations omitted).

3 Although Defendants emphasize Plaintiffs failure to offer motive evidence, such as sales of stock by theIndividual Defendants, the Supreme Court has recently held that:

While it is true that motive can be a relevant consideration, and personal financial gain may weighheavily in favor of a scienter inference, we agree with the Seventh Circuit that the absence of amotive allegation is not fatal. As earlier stated, allegations must be considered collectively; thesignificance that can be ascribed to an allegation of motive, or lack thereof, depends on the entirety ofthe complaint.

Tellabs, 551 U.S. at 325 (citations omitted).CV-90 (06/04) CIVIL MINUTES - GENERAL Page 12 of 19

subsequently made further misstatements in seeking to explain these differences.2 Moreover,Plaintiff specifically alleges in the complaint that [a]lthough there is some disparity betweenChinese accounting methodology and U.S. accounting standards, these deviations cannotrationally explain the incredible differences of magnitude between the numbers reported inChina and those reported in ZSTs SEC filings. (Compl. 45.)3




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2. AUDITOR LIABILITY

Defendant Kempisty, ZSTs outside auditor, moves separately to be dismissed from theExchange Act claims. The Court finds that Plaintiff has not adequately pleaded falsity andscienter with respect to Kempisty.

Any person or entity, including a lawyer, accountant, or bank, who employs amanipulative device or makes a material misstatement (or omission) on which a purchaser orseller of securities relies may be liable as a primary violator under 10b5, assuming all of therequirements for primary liability under Rule 10b5 are met. Central Bank of Denver, N.A. v.First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994). See also McGann v. Ernst &Young, 102 F.3d 390 (9th Cir. 1996).

Plaintiff alleges that Kempisty made false statements in an audit opinion attached to theCompanys SEC filings, in particular when it represented that [w]e have audited theaccompanying consolidated balance sheets of ZST Digital Networks, Inc. . . . In our opinion, theconsolidated financial statements referred to above present fairly, in all material respects, thefinancial position of ZST Digital Networks, Inc. . . . . (Compl. 64.) However, Plaintiffsallegations that Kempisty was an experienced auditor of Chinese issuers financials, and musthave been aware of the existence of the SAIC filings, a mere glance [at which] would havereadily lead to the discovery of the discrepancies, is insufficient to constitute the recklessindifference required by the case law. See New Mexico Inv. Council v. Ernst & Young LLP,641 F.3d 1089, 1095 (9th Cir. 2011) ([T]he more likely an auditor would have discovered thetruth if a reasonable audit had been conducted, the stronger the scienter inference.)

In New Mexico, the Ninth Circuit reiterated that [t]ypically, pleading sufficient facts tosupport a strong inference of scienter by an outside auditor is difficult because outsider auditors

have more limited information than, for example, the company executives who oversee theaudit. Id. at 1098. The Court of Appeals elaborated on the standard a court should apply tosuch allegations:

In examining allegations of scienter, courts have looked at a range of factors forpotential red flags, including the interaction of auditors with company executivesand the breadth and scope of the auditor's deviation from GAAP or GAAS.

The red flag doctrine guides the GAAP and GAAS inquiries: the more facts allegedthat should cause a reasonable auditor to investigate further before making a




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representation, the more cogent and compelling a scienter inference becomes.Scienter requires more than a misapplication of accounting principles. The plaintiffmust prove that the accounting practices were so deficient that the audit amounted tono audit at all, or an egregious refusal to see the obvious, or to investigate thedoubtful, or that the accounting judgments which were made were such that noreasonable accountant would have made the same decisions if confronted with thesame facts.

Id. (internal citations omitted).

Plaintiff has not alleged that Kempisty had any knowledge of the existence of the SAICreports, nor that it ignored their divergent revenue figures, nor that being ignorant of theirexistence constituted an egregious refusal to see the obvious, or to investigate the doubtful.Rather, the allegations against the Companys outside auditor are entirely derivative of theallegations against ZST and its executives. Accordingly, its motion is GRANTED andPlaintiffs claim under Section 10(b) is DISMISSED with leave to amend as against Kempisty.

3. LOSS CAUSATION

Defendants also contend that Plaintiff has failed to adequately plead loss causation,because the existence of differences between the Companys SAIC and SEC filings were notrevealed for the first time in the article posted on seekingalpha.com in April 2011 by the SecondShort Seller, but were revealed nearly six months earlier in the article posted on that very samewebsite by the First Short Seller. (ZST-Mem. at 19.)

Loss causation is defined as a causal connection between the material misrepresentationand the loss. Dura Pharmaceuticals, 544 U.S. at 341. The Ninth Circuit has recently held that,at the pleading stage, a plaintiff must provide the defendant with only some indication that thedrop in [the defendants] stock price was causally related to [its] financial misstatements. In reDaou Systems, Inc., 411 F.3d 1006, 1026 (9th Cir. 2005) (citing Dura Pharmaceuticals, 544 U.S.at 347 (requiring a plaintiff who has suffered an economic loss to provide a defendant withsome indication of the loss and the causal connection that the plaintiff has in mind).

Defendants citation to a previous article containing allegations of wrongful behavior atthe Company cannot overcome the Plaintiffs pleading of loss causation. Plaintiff alleges thatZSTs stock price fell precipitously over forty percent on April 21, 2011, the same day thepurported article allegedly alerted the market to the existence of disparate sets of accountingreports. (Compl. 88.) Accordingly, the Court finds that the Plaintiff has given Defendants




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more than some indication as to the causal mechanism which is alleged to connect thepurported revelation and the drop in the Companys share price.

4. RELIANCE

Similarly, Defendants contend that Plaintiff has not adequately pleaded that he relied onthe alleged misstatements, because the information which the Defendants were alleged to have

withheld from or misrepresented to the market had been previously disclosed through otherchannels, namely the prior article discussed above. (ZST-Mem. at 16-17.)

To claim a fraud-on-the-market presumption, as Plaintiff has here, one must establish:[1] that the defendant made public misrepresentations; [2] that the misrepresentations werematerial; [3] that the shares were traded on an efficient market; . . . and [4] that the plaintifftraded the shares between the time the misrepresentations were made and the time the truth wasrevealed. Basic Inc. v. Levinson, 485 U.S. 224, 248 (1988). Notwithstanding Plaintiffspleading of these elements, Defendants rely on the truth-on-the-market defense, whichrequires them to show that the information alleged to have been withheld or misrepresented wastransmitted to the public with a degree of intensity and credibility sufficient to effectivelycounterbalance any misleading impression created by [an] insider's one-sided representations.Provenz v. Miller, 102 F.3d 1478, 149293 (9th Cir.1996). As a general rule, however, thetruth-on-the-market defense is intensely fact-specific, so courts rarely dismiss a complaint onthis basis. Nguyen v. Radient Pharmaceuticals Corp., 2011 WL 5041959, at *7 (C.D. Cal. Oct.20, 2011) (citing In re Amgen Inc. Securities Litigation, 544 F.Supp.2d 1009 (C.D. Cal. 2008)).

In light of the markets non-reaction to the previous article a drop in the Companysshare price of one percent, according to Plaintiff and its vigorous reaction to the publication ofthe April 21, 2011 article, the Court concludes that the issue is not appropriate for resolution atthe pleading stage. The Court cannot say at this time that the relevant information had been

transmitted with the requisite degree of intensity and credibility prior to April 21.

5. CONCLUSION RE:EXCHANGE ACT CLAIMS

As to Plaintiffs third and fourth causes of action, Defendant ZSTs motion to dismiss isDENIED. The motion of Defendant Kempisty urging dismissal of the same claims isGRANTED. Plaintiff will, however, have an opportunity to amend his complaint in order toadequately plead these claims against Kempisty.

C. SECURITIES ACT CLAIMS




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Plaintiffs first cause of action is asserted under Section 11 of the Securities Act, againstall Defendants except for Defendants Chen and Na. (Compl. 61.) Plaintiff alleges that all suchDefendants are liable for misstatements and/or omissions contained in the Registration Statementbecause [1] the Individual Defendants, except for Defendants Chen and Na, signed the Statementand, as directors and officers of ZST, and controlling persons of the issuer, owed to the holdersof ZST Securities obtained through the Registration Statement the duty to make a reasonable anddiligent investigation of the statements contained within it; [2] the Underwriter Defendants and

Kempisty owed the same duty, and as agents of ZST had ready access to the Companys filingswith the SAIC, and failed to ensure that its SAIC filings were included or referenced in theRegistration Statement. (Id. 63-65.)

Section 11 of the Securities Act of 1933 provides a cause of action against issuers,underwriters, auditors and all persons signing a registration statement that contain[s] an untruestatement of a material fact or omit[s] to state a material fact required to be stated therein ornecessary to make the statements therein not misleading. 15 U.S.C. 77k(a). That sectionwas designed to assure compliance with the disclosure provisions of the Act by imposing astringent standard of liability on the parties who play a direct role in a registered offering.Herman & MacLean v. Huddleston, 459 U.S. 375, 381 (1983). Accordingly, to establish a primafacie case under Section 11, a plaintiff need only show a material misstatement or omission.Id.; see also Daou, 411 F.3d at 1027 (The plaintiff in a [Section 11] claim must demonstrate (1)that the registration statement contained an omission or misrepresentation, and (2) that theomission or misrepresentation was material, that is, it would have misled a reasonable investorabout the nature of his or her investment.) (citations omitted). The plaintiff need notdemonstrate scienter, reliance, or loss causation. Id. Although [S]ection 11 does not contain anelement of fraud, a plaintiff may nonetheless be subject to Rule 9(b)'s particularity mandate if hiscomplaint sounds in fraud. Daou, 411 F.3d at 1027.

Defendants contend that Plaintiffs Section 11 claim fails on numerous grounds. Because

the Court concludes that Plaintiff has not alleged sufficient facts demonstrating that he hasstanding to sue under Section 11, it does not address Defendants alternative arguments fordismissal.

1. TRACEABILITY AND STANDING

Defendants contend that Lead Plaintiff Gray has failed to adequately plead that his shareswere issued pursuant to or are traceable to the applicable Registration Statement, as required by15 U.S.C. 77k(a).




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4 The court nevertheless agree[d] with the Century Aluminum analysis and the conclusion that post-Twombly and Iqbal, Plaintiffs do not adequately allege standing simply by stating they purchased sharestraceable to the Registration Statement and Prospectus. 2011 WL 2669217, at *14.CV-90 (06/04) CIVIL MINUTES - GENERAL Page 17 of 19

To have standing to bring suit under Section 11, a plaintiff must have purchased stock inthe offering at issue, or trace later-purchased stock back to that offering. Plichta v. SunPowerCorp., 790 F.Supp.2d 1012, 1022 (N.D. Cal. 2011) (citing Hertzberg v. Dignity Partners, Inc.,191 F.3d 1076, 1080 n. 4 (9th Cir. 1999)). District courts in this circuit addressing the issuehave uniformly held that mere boilerplate allegations of traceability are insufficient to establishsuch standing. See, e.g., Plichta, 790 F.Supp.2d at 1022-1023 (Plaintiffs have not explained,however, how even with discovery, they hope to be able to prove that any of their shares are

traceable to the original offering, given that the shares are fungible and that millions of shareswere already being traded on the open market at the time of the offering.); In re CenturyAluminum Co. Securities Litigation, 749 F.Supp.2d 964 (N.D. Cal. 2010) (Plaintiffs haveneither alleged in the FAC, nor have they articulated in their oppositions, how to trace anyparticular shares in the 75 million share pool that existed after the secondary offering to showthat those shares came from the secondary offering.)

In In re STEC Inc. Securities Litigation, a district court in this District noted the languageused in cases such as Plichta and Century Aluminum, and held that, under the relevant case law,a plaintiff need not plead facts that prove their securities are traceable to the secondary offering,but [must] plead facts showing that their shares can be traced. 2011 WL 2669217, at *14 (C.D.Cal. 2011).4 That interpretation accords with the Ninth Circuits own discussion of the issue inHertzberg, where the Court of Appeals explained that:

The limitation on any person is that he or she must have purchased such security.Clearly, this limitation only means that the person must have purchased a securityissued under that, rather than some other, registration statement. While it mightpresent a problem of proof in a case in which stock was issued under more than oneregistration statement, the only Dignity stock ever sold to the public was pursuant tothe allegedly misleading registration statement at issue in this case.

191 F.3d 1076, 1080 (internal citation omitted). At least one court in this District has been moreliberal in construing Section 11's standing requirement. See In re SeeBeyond TechnologiesCorp. Securities Litigation, 266 F.Supp.2d 1150, 1171-1172 (C.D. Cal. 2003) (finding allegationthat a plaintiff purchased [the defendants] common stock issued pursuant to the registrationstatement/prospectus filed by the Company with the SEC sufficient to establish Section 11standing at the pleading stage).




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Defendants note the existence of a second registration of ZSTs securities on January 14,2010, before Lead Plaintiff Gray purchased his shares. According to the certification offered byGray, his shares were purchased on March 3, 2011 and March 11, 2011, fifteen months after theoriginal IPO and thirteen months after the second registration. (Docket No. 11, Declaration ofMichael Goldberg (Goldberg Decl.), Ex. C [Shareholder Certification].) In opposition,Plaintiff avers that, as of August 2011 after the Class Period none of the shares issued in the

second registration had sold into any public market. (Opp. at 19.) Plaintiff cites a 10-K filedby the company on August 2, 2011, which states that in January 2010, we registered 1,086,400shares of common stock held by affiliates of WestPark, all of which may be freely sold andtransferred. (Hibbard Decl., Ex. J [Amended 2010 10-K.].) Plaintiff focuses on that filingsuse of the word may, arguing that the mere fact of registration of these additional shares doesnot raise the possibility that Lead Plaintiffs publicly purchased shares could be traceable to anyRegistration Statement other than the one at issue in this action. (Opp. at 20.) However,Defendants note in reply that shares registered in the second Registration Statement had indeedbeen sold in the public market by the time Gray bought his shares in March 2011. (Docket No.85, UW-Rep. at 6-7.) Moreover, an argument similar to Plaintiffs, as Defendants note, wasrecently rejected by a court in this District. Katz, 2011 WL 6047093, at *5 (Although Plaintiffssuggest that Katz and Shapiro must have bought in the IPO, because a planned resale of sharesreleased under a private placement agreement did not occur, Plaintiffs allegations do not ruleout the possibility that Katz and Shapiro purchased their shares in a manner not traceable to theIPO. Thus, Plaintiffs must plead with more specificity that Katz and Shapiro purchased theirshares in a manner traceable to the IPO.)

The Court finds that, as currently pleaded, the complaint cannot satisfy Section 11'sstanding requirements. Plaintiff has alleged only that he purchased ZST securities at artificiallyinflated prices during the Class Period and has been damaged thereby, and brings suit onbehalf of persons who acquired shares of ZST Securities pursuant or traceable to the Registration

Statement in connection with the IPO. (Compl. 11, 29, 61.) Even under the more liberalpleading standard articulated in SeeBeyond, those allegations are insufficient. 266 F.Supp.2d at1171-1172; see also Katz, 2011 WL 6047093, at *5 (distinguishing between particular allegationthat plaintiff purchased shares during the IPO, and generalized allegations that [e]ach ClassMember acquired his, her, or its shares in, pursuant to and/or traceable to, and in reliance on, theRegistration Statement and Prospectus, and finding the latter insufficient). Plaintiff need notplead facts proving that his shares are traceable to the Registration Statement in question, but[must] plead facts showing that [his] shares can be traced. STEC Inc., 2011 WL 2669217, at*14.




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Because the Court finds that Gray lacks standing under Section 11, that claim, along withhis claim under Section 15 of the Securities Act, must be DISMISSED. Plaintiff will, however,have an opportunity to amend his complaint in order to adequately plead that the shares werepurchased in the offering at issue, or can be traced back to that offering. Until Plaintiff does so,the Court need not address Defendants various other grounds for dismissal of his Section 11claims.

IV. CONCLUSION

For the reasons set forth above, the motions are GRANTED in part and DENIED inpart. Plaintiffs first and second claims, for violations of Sections 11 and 15 of the SecuritiesAct, are DISMISSED with leave to amend. Plaintiffs claims for violations of Sections 10(b)and 20(a) of the Exchange Act are DISMISSEDwith leave to amend as against DefendantKempisty. In all other respects, Defendants motions are DENIED. Failure to file an amendedcomplaint curing the deficiencies outlined above by March 9, 2012 will be deemed consent todismissal of the claims with prejudice.

IT IS SO ORDERED.



Documents

Partial Dismissal of Zst