defendant may make such an argument “in any pleading permitted or ordered under Rule 7(a)', or
by motion for judgment on the pleadings, or.at.the trial on the merits.” Fed.R.Civ.P. 12(h)(2).
Under Rule 12(g), however, the defendants may not “assert the defense by a second pre-answer
motion” because Rule 12(g) expressly precludes the defendant from doing so. Wright & Miller,
§1392. “The filing of an amended complaint will not revive the right to present by motion
defenses that were available but were not asserted in timely fashion prior to amendment.”

Wright & Miller §1388. See also Harris Bank.y. Pachaly, 902 F.Supp. 156 (N.D. Ill 1995); Dee-
K Enterprises, Inc. v. Heveafil Sdn, Bhd., 985 F.Supp. 640, 642 n.2. (D. Va. 1997).

Because Smithburg and Walter did notraise before the arguments they make now
regarding counts one and two, Smithburg and Walter are precluded from raising these arguments
in this their third motion to dismiss. Accordingly, Smithburg and Walter’s motion to dismiss
counts one and two of the Second Amended Complaint is denied.

B. Count Ten -- Illinois Consumer Fraud Act

In Wafra I, Judge Bucklo dismissed count ten as to Smithburg and Walter for failure to
plead fraud with particularity. Judge Bucklo found that the complaint satisfied the who, what
and when components of fraud under Rule 9(b), but held that Wafra had failed to satisfy the
“how” element. Specifically, Judge Bucklo found that Wafra had not made any “allegation that
they knew, or ever should have known about the kiting scheme that the 10-K reports failed to

disclose.” 204 F.Supp.2d at 1126. In an attempt to remedy this defect, Wafra has added an

* Rule 7(a) provides, in relevant part: “There shall be a complaint and an answer; a reply to a
counterclaim denominated as such; an anser to_a.cross-claim, if the answer contains a cross-
claim; a third-party complaint, if a person who was not an original party is summoned under the
provisions of Rule 14; and a third-party answer, if a third-party complaint is served.” Fed. R.
Civ. P. 7(a).

19


repose. The question, therefore, is what constitutes the violation that triggers the statute of
repose period for a Section 10(b) and/or Rule 10b-5 claim premised on an alleged violation of the
“duty to correct” -- the time the alleged misrepresentation was originally made or the time when
duty to correct arose.

In Wafra I, Judge Bucklo held that “the ‘violation’ for the purposes of the Rule 10b-5
statute of repose occurs when the defendant makes a misrepresentation in connection with the
sale or purchase of securities; the sale itself need not have occurred to start the running of the
repose period.” Wafra I, 192 F.Supp.2d at 864, See also Stauffer v. Westmoreland Obstetric &
Gynecologic Assocs., 2001 WL 585510, at *5 (N.D. Ill. May 25, 2001). Because the alleged
misrepresentation occurred when KPMG issued the 1997 audit on March 27, 1998, Judge Bucklo
dismissed the claims against KPMG based on the 1997 audit because those claims had been filed
more than three years after the alleged misrépresentation.

In the context of a securities fraud claim, the duty to correct “applies when a company
makes a historical statement that, at the time made, the company believes to be true, but as
revealed by subsequently discovered information, actually was not. The company then must
correct the prior statement within a reasonable time.” Stransky v. Cummins Engine Co., Inc., 51
F.3d 1329, 1332 (7" Cir. 1995). Because the Company believed that its misrepresentation was
true at the time it was made, the company’s conduct would not be actionable under Section 10(b)
and/or Rule 10b-5 at the time the misrepresentation was originally made. See Lampf, 501 U.S. at
377 (Section 10(b) requires “‘scienter on the part of the defendant”).

As Wafra alleges in the alternative in colint eleven, there was no “violation” when KPMG

issued its audit report on the 1997 financial statements because KPMG believed, at the time, that

13


4134.) Further, Plaintiff claims that it relied. on a May 4, 1999 Letter from KPMG. (/d. J 160.)
Wafra alleges that KPMG knew or should haye known that investors such as Wafta would rely
on both the 1997 audit and the May 4, 1999 Letter. (Id. ¥ 135, 161.)

On May 28, 1999, Prime filed the delayed 1998 10-K with the SEC. (R. 89-1, Second
Am. Compl., § 134.) KPMG’s audit report of Prime Capital’s 1998 financial statements, dated
May 20, 1999, was included with the 10-K. Gd.) The audit report was dated a mere sixteen days
after the closing of the 1999-A securitization. (Jd.) KPMG disclosed in the audit that in 1999
Prime had transferred several million dollars to the SPVs that should have been transferred in
1998. On November 1, 1999, Prime announced that KPMG had resigned as of October 26, 1999.
(Id. 50.) Prime Capital noted that KPMG had brought to its attention “the existence of certain
irreconcilable differences between the account,detail and the general ledger and information
included in the account detail which could not be substantiated. Many of these differences relate
to transactions that occurred in prior years. An adjustment to the consolidated financial
statements was not required by KPMG.” (Jd.)

In April 2000, the securitization trustee notified Prime that there had been several defaults
under the indentures and servicing agreements. (R. 89-1, Second Am. Compl., 4 54). On June 9,
2000, Prime announced that it would no longer be financially capable of honoring its obligations
to Plaintiff and other investors. (Jd. 6, 55.) Prime also disclosed the misappropriation of
some of the funds. (/d.)

B. Procedural Background

Watfta sued Prime Capital, its subsidiariés, several of its officers and directors (including

Smithburg and Walter), KPMG, and Prime’s attorneys for securities fraud under Section 10(b) of


allegation that Smithburg and Walter “knew or, in the alternative, should have known about
Prime’s Diversion, Misappropriation and Kiting scheme.” (R. 89-1, Second Am. Compl., { 100.)

To state a cause of action under the ICFA, a plaintiff must allege: (1) a misrepresentation
or concealment; (2) of a material fact; (3) made with the intent to induce reliance; and (4) ina
course of conduct involving trade or commerce. Gelco Corp. v. Major Chevrolet, Inc., 2002 WL
31427027, at*10 (N.D. Ill.). ICFA claims must satisfy the heightened pleading requirements
under Rule 9(b). Unique Coupons, Inc. v. Northfield Corp. 2000 WL 631324, at *3 (N.D. Ill.
2000). Because count ten alleges an ICFA violation and not a federal securities fraud claim,
however, the heightened pleading requirements under the PSLRA do not apply.

As an initial matter, this Court previously denied Smithburg and Walter’s Motions to
Strike Additional Affirmative Matter in Plaintiff's Reply, noting that the exhibits attached to
Watfra’s opposition to the motion dismiss, as well as any facts derived from these exhibits, may
be considered in deciding the motion to dismiss. Indeed, a party “need not put all of the essential
facts in the complaint; he may add them by affidavit or brief” as long as the “facts are consistent
with the allegations of the complaint.” Help AtHome Ine. v. Medical Capital, L.L.C., 260 F.3d
748, 752-53 (7" Cir. 2001). See also Hrubec v, National R.R. Passenger Corp., 981 F.2d 962,
*963 (1992) (“‘A plaintiff need not put all of the.essential facts in the complaint. He may add
them by affidavit or brief’); Anzaldua v. Chicago Transit Authority, 2002 WL 31557622, at *2
(N.D. Ill.) (“We will consider additional information in a responsive brief to a motion to dismiss

to the extent that it is supplemental and consistent with the complaint and clarifies the

20


CONCLUSION
For the reasons stated above, Defendant KPMG’s motion is granted in part and denied in

part, and Defendants Smithburg and Walter’s motion is denied.

Dated: November 25, 2002 ENTERED:

United States District Judge

22


the requisite scienter at the time KPMG issued its 1997 Audit opinion, but that KPMG

Capital began putting the 1999-A Securitization together and May 4, 1999 when the 1999-A
Securitization closed. (R. 89-1, Second Am. Compl., { 189.) Wafra supports this contention, in
part, by the timing of the audit report on Prime’s 1998 financial statements, which was released
just sixteen days after the May 4, 1999 closing. Wafra points to the substantial delay in the
release of the 1998 audit as evidence that KPMG was aware of the fraud prior to the closing on
May 4, 1999. (/d. 147.) Further, Wafia suggests that the inclusion of an “intentionally obscure
note” in the 1998 10-K confirms that KPMG was aware of the alleged fraud prior to the filing of
the 1998 10-K. This “intentionally obscure note” disclosed that as December 31, 1997, Prime
Capital had some $3.5 million on hand that should have been transferred to the SPVs in 1997.
(id.) Thus, Wafra argues that KPMG actually knew about the fraud revealed in its 1998 audit
and that KPMG had a duty to correct its 1997 audit prior to the closing.

Taken as a whole, this Court concludes that Wafra’s allegations satisfy the heightened
pleading requirements for scienter under Rule 9(b) and the PSLRA and support a strong
inference of recklessness by KPMG. See Ackerman, 947 F.2d at 848-49 (if defendant “came to
doubt the representations in his letter but continued to allow its circulation, this may be powerful
evidence of recklessness”). Accordingly, KPMG’s motion to dismiss count eleven is denied.
WW. — Smithburg and Walter’s Motion to Dismiss

Smithburg and Walter have moved to dismiss the Second Amended Complaint, arguing

that Wafra has failed to allege fraud with particularity. Although they suggest that they seek to

17


beyond doubt that under no set of facts would plaintiff's allegations entitle him to relief.
Henderson v. Sheahan, 196 F.3d 839, 846 (7" Cir. 1999); Kennedy v, Nat'l Juvenile Det. Assoc.,
187 F.3d 690, 695 (7" Cir. 1999). The complaint, however, must allege the elements of each
cause of action in order to withstand a motion to dismiss. Lucien v. Preiner, 967 F.2d 1166,
1168 (7" Cir, 1992).
I. KPMG’s Motion to Dismiss

KPMG argues that Plaintiff has failed to state a claim against it with counts eight and
eleven of the Second Amended Complaint. Both counts allege securities fraud in violation of
Section 10(b) of the Securities Exchange Act and Rule 10b-5. The elements of a Section 10(b)
claim are that: (1) the defendant made a false statement or omission; (2) of a material fact; (3)
with scienter; (4) in connection with the purchase or sale of securities; (5) upon which the
plaintiff justifiably relied; (6) and the false statement proximately caused the plaintiffs' damages.
Caremark, Inc. v. Coram Healthcare Corp., 113 F.3d 645, 648 (7" Cir. 1997). See also Tatz v.
Nanophase Technologies Corp, 2002 WL 31269485, at *4 (N.D. Ill. Oct. 9, 2002).

A Count Eight -- Securities Fraud

Count eight premises its theory of liability against KPMG on KPMG’s May 4 Letter. The
May 4 Letter is addressed to Prime leasing, Prime Finance Corporation 1999-A-1, Prime
Financing corporation 1999-A-2 and Merrill Lynch & Co. (See R. 101-1, KPMG’s Mem. of Law
in Support of Mot. to Dismiss, Ex. A.) Wafra was not an addressee of the May 4 Letter. In the
May 4 Letter, KPMG states that it performed certain “agreed-upon procedures” “in accordance
with standards established by the American Institute of Certified Public Accountants.” (/d.)

KPMG specifically included the following disclaimer in the letter: “The sufficiency of the


in the May 4 Letter that constituted a misreprésentation. Specifically, Judge Bucklo found:

Wafra does not explain how. it.could reasonably have relied on the

statement that no audit had been conducted in making its

investment decision; reliance.on an auditor’s statement that it had

not conducted an audit as confirmation that everything was okay

with the transaction is both implausible and unreasonable.
Wafra I, 192 F.Supp.2d at 867. Further, Judge Bucklo noted that KPMG specifically stated in
the May 4 Letter that “it had not performed any procedures to verify the information in the
schedules provided by Prime.” Jd. In light of this disclaimer, Judge Bucklo found that Wafra
failed to identify any misleading statement in the May 4 Letter. Jd.

In addition, Judge Bucklo held in Wafra_J that the three year statute of repose for
securities fraud claims barred the claim against KPMG based on its 1997 audit opinion. Wafra I,
192 F.Supp.2d at 864. Noting that the repose period for Section 10(b) claims commences at the
time of the violation, Judge Bucklo found that the “violation” for a claim based upon a false
misrepresentation “occurs when the defendant makes a misrepresentation in connection with the
sale or purchase of securities.” Jd. at 864. Because Wafra did not file its suit against KPMG
until June 8, 2001-- more than three years after.the audit opinion and the alleged
misrepresentation issued on March 27, 1998 -- Judge Bucklo held that the statute of repose
barred the Section 10(b) claims based on that audit. Jd. at 864-65.

D. May 24, 2002 Opinion

On May 24, 2002, Judge Bucklo issued an opinion addressing Smithburg and Walter’s
arguments to dismiss count ten of the Amended.Complaint. Wafra Leasing Corp. 1999-A-I v.
Prime Capital Corp., 204 F.Supp.2d 1120, 1126 (May 28, 2002) (“Wafra II”). In Wafra II,

Judge Bucklo held that Wafra had not pled with particularity its ICFA claim as to Smithburg and


the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10-5, and for “control
person” liability under Section 20(a) of the Exchange Act. Wafra subsequently filed an
Amended Complaint, adding count ten, which alleged that Defendants, including Smithburg and
Walter, violated the Illinois Consumer Fraud.and Deceptive Business Practices Act, 815 ILCS
505/1 (the “ICFA”).

Defendants filed various motions to disthiss the Complaint and Amended Complaint. On
August 17, 2001, for example, KPMG moved.to certain counts of the Complaint, and on
February 4, 2002, KPMG moved to dismiss ‘count ten of the Amended Complaint. On January
15, 2002, Smithburg and Walter moved to dismiss the Complaint by adopting the arguments set
forth in a motion to dismiss filed by co-defendants Thomas Ehman and Vern Landeck. On
January 18, 2002, Smithburg and Walter movéd to dismiss the Amended Complaint, again
adopting arguments raised by Ehman and Landeck but also raising the argument that count ten
failed to allege fraud with particularity as required under Federal Rule of Civil Procedure 9(b).

Cc. The March 25, 2002 Opinion

On March 25, 2002, Judge Bucklo granted KPMG’s motion to dismiss in part. See Wafra
Leasing Corp.1999-A-1 v. Prime Capital Corp., 192 F.Supp.2d 852 (N.D. Ill. 2002) (“Wafra r’)'.
Specifically, Judge Bucklo dismissed the securities fraud claims against KPMG based on the
May 4, 1999 Letter because she concluded that. Wafta could not have reasonably relied on the

statement that no audit had been conducted and.Wafta had not identified any specific statement

' This case was pending before Judge Bucklo until August 30, 2002, when it was reassigned by
order of the Executive Committee to this Court. ©

5


dismiss only count ten which alleges an ICFA violation, it seems that Smithburg and Walter
actually seek to dismiss the securities fraud claims in counts one and two as well.

A. Counts One and Two -- Securities Fraud Claims

This is actually Smithburg and Walter’s third motion to dismiss for failure to state a
claim. On January 15, 2002, they moved to dismiss the Complaint, adopting the arguments made
by Ehman and Landeck. After Wafra filed an Amended Complaint (adding a new count ten) on
January 15, 2002, Smithburg and Walter filed another motion to dismiss, again adopting
arguments raised by Ehman and Landeck but also raising additional arguments concerning count
ten. Smithburg and Walter have now moved to dismiss the Second Amended Complaint, raising
arguments with respect to counts one and two. that they failed to advance in either of their
previous motions to dismiss.

Rule 12(g) provides that “[i]fa party makes a motion under this rule but omits there from
any defense or objection then available to the party which this rule permits to e raised by motion,
the party shall not thereafter make a motion based on the defense or objection so omitted, except
a motion as provided in subdivision (h)(2) hereof on any of the grounds there stated.” Fed. R.
Civ. P, 12(g). Thus, Rule 12(g) generally precludes a defendant from bringing successive
motions to dismiss raising arguments that the defendant failed to raise at the first available
opportunity. See Albany Insc. Co. v. Almacenddora Somex, 5 F.3d 907, 909 (5" Cir. 1993)

Rule 12(h)(2) provides that where a defendant fails to raise a defense or objection in an

initial motion to dismiss for failure to state a claim, the defendant does not waive it. Instead, the

18


In count eleven, Wafra alleged that KPMG believed the statements in the 1997 audit
report “to be true at the time when it made them,” but that “[a]t some point subsequent to
September 1998 and before the closing of the 1999-A securitization on May 4, 1999, KPMG
learned of Prime’s Diversion, Misappropriation and Kiting scheme.” (R. 89-1, Second Am.
Compl.,{{[ 188-89.) Wafra further alleged that. KPMG “knew that Plaintiff was relying on these
1997 statements in making its decision whether to invest in the 1999-A Securitization,” and
therefore had a “duty to correct” its statements pertaining to the 1997 financial statements. (/d. at
9 190-91.) Wafra claimed that KPMG violated its duty to correct by failing to correct the 1997
financial statements. (/d.)

ANA LYSIS
L Legal Standards

The purpose of a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) is to
test the legal sufficiency of a complaint, not the'merits of the case. Triad Associates, Inc. v.
Chicago Hous. Auth., 892 F.2d 583, 586 (7" Cir. 1989); Majchrowski v. Norwest Mortgage, 6
F.Supp.2d 946, 952 (N.D. Ill. 1998). In ruling ona motion to dismiss for failure to state a claim,
the court considers “whether relief is possible under any set of facts that could be established
consistent with the allegations.” Bartholet v. Reishauer A.G., 953 F.2d 1073, 1078 (7" Cir.
1992). The court views all the facts alleged in the complaint, as well as any reasonable
inferences drawn from those facts, in the light most favorable to the plaintiff, and construes the
allegations liberally. Stachon v. United Consumers Club, Inc., 229 F.3d 673, 675 (7" Cir. 2000),
Doherty v. City of Chicago, 75 F.3d 318, 322 (7" Cir. 1996); Taiz v. Nanophase Tech. Corp.,

2002 WL 31269485 at *3 (N.D. Ill. Oct. 9, 2002). Dismissal is appropriate only where it appears


*

Minute Ofder Form (06/97)

United States District Court, Northern District of Illinois

i J Sitting Judge if Oth
vege Maghtrate Judge Amy J. St. Eve than Aesigned Judge
CASE NUMBER 01 C 4314 DATE 11/25/2002
CASE Wafra Leasing Corporation vs. Prime Capital Corporation
TITLE

{In the following box (a) indicate the party filing the motion, e.g,, plaintiff, defendant, 3rd party plaintiff, and (b) state briefly the nature

of the motion being presented.)

MOTION:

DOCKET ENTRY:

(1) QO Filed motion of [ use listing in “Motion” box above.]

(2) oO Brief in support of motion due

(3) Oo Answer brief to motion due___. Reply to answer brief due_____.

(4) o Ruling/Hearingon__setfor_____at

(5) Oo Status hearing[held/continued to] [set for/re-set for]on__—ssetfor_——sat_—
(6) Oo Pretrial conference[held/continued to] {set for/te-set forlon_—ssetfor_ at
7) im} Trial[set for/re-set for]on__——sat__—.

(8) o [Bench/Jury trial] [Hearing] held/continued to,

(9) Oo This case is dismissed [with/without] prejudice and without costs[by/agreement/pursuant to]

OOFRCP4(m) (OLocal Rule 41.1 CFRCP41(a)(1)  FRCP41(a)(2).

go [Other docket entry] Enter Memorandum Opinion and Order. Defendant KPMG's motion
to dismiss is granted in part and denied_in part. Count eight is dismissed with prejudice.
Defendants Smithburg and Walter's motion to dismiss is denied.
(1) [For further detail see order attached to the original minute order.]
No notices required, advised in open court.
No notices required. umber of novices
Notices mailed by judge’s staff. Wor 2 & 20.
Notified counsel by telephone. a te docketed
o¥ { Docketing to mail notices. n lV \0
| Mail AO 450 form. uned sigisia ‘sn DA wom \
AG
Copy to judge/magistrate judge.
Oh 4 Hd Sz AON 20 ac mbodt
7] courtroom —
TI deputy’s 7 9-1
deputy’s Qi Us-0F014
Date/time.received in
central, Clerk’s Office nating deputy nals
tian



that if an accountant “becomes aware of a potentially material adjustment to that account by
means other than performance of the agreed-upon procedures, the accountant should include this
matter in his or her report.” (R. 101-1, KPMG’s Mem. of Law in Support of Mot. to Dismiss,
Ex. B, at 1073.) Wafra alleges that KPMG represented in the May 4 Letter that it was not aware
of any information that would “significantly contradict” the “bases for accounting” used by
KPMG or of any “potentially material adjustment” to the accounts that were the subject of the
May 4 Letter. (R. 89-1, Second Am. Compl., { 153.) Wafra contends that KPMG knew of the
cash flow diversion by Prime and failed to disclose it as required by SAS No. 75, and that KPMG
affirmatively misrepresented that the May 4 Letter complied with the AICPA standards and the
requirements of SAS No. 75. (Id. J] 153-159.)

However, the very accounting provision upon which P)aintiff relies, as well as the plain
language of the May 4 Letter, defeat Wafra’s argument that it could have reasonably relied upon
the May 4 Letter. SAS No. 75 specifically provides that “[a]s a consequence of the users’ role in
agreeing upon the procedures performed or to be performed, an accountant’s report on such
engagements should clearly indicate that its us@.is restricted to those users. (R. 101-1, KPMG’s
Mem. of Law in Support of Mot. to Dismiss, Ex. B, at 1062.) In accordance with this provision,
the May 4 Letter specifically notes: “This report‘is intended solely for the use of the addresses
and should not be used by those who have not agreed to the procedures and taken responsibility
for the sufficiency of the procedures for their ptirposes.” (/d., Ex. A, at 2.) Wafira was not an

addressee of the May 4 Letter. Moreover, Wafta does not allege that it agreed to the procedures

11


procedures is solely the responsibility of the addressees of the report. Consequently, we make no
representation regarding the sufficiency of the procedures described below either for the purpose
for which this report has been requested or for any other purpose.” (/d.) Moreover, KPMG
noted that it was “not engaged to perform an audit, the objective of which would be the
expression of an opinion on the specified elements, accounts, or items. Accordingly, we do not
express such an opinion. Had we performed additional procedures, other matters might have
come to our attention that would have been reported to you.” (/d. at 6.) Finally, KPMG
expressly disclaimed: “This report is intended solely for the use of the addressees and should
not be used by those who have not agreed to the procedures and taken responsibility for the
sufficiency of the procedures for their purposes.” (Id. (emphasis added),)

KPMG argues that Wafra fails to state a claim for securities fraud because of the express
statement upon which Plaintiff relies is not misleading, that Wafra could not reasonably have
relied on any statements in the May 4, 1999 Letter, and that Wafra has failed to allege scienter
with particularity.

Watfra, of course, argues that count eight does state a cause of action for securities fraud.
Watfra contends that count eight alleges an expréss misrepresentation in the May 4 Letter by
KPMG upon which Plaintiff reasonably relied. The May 4 Letter states that it “was performed in
accordance with standards established by the Anjerican Institute of Certified Public Accountants
(“AICPA”).” (See R. 101-1, KPMG’s Mem. of Law in Support of Mot. to Dismiss, Ex. A, at 1.)
Plaintiff argues that SAS No.75 is the standard governing the May 4 Letter and, therefore, the

SAS No.75 standards are incorporated by reference in the May 4 Letter. SAS No. 75 provides

10


Walter. Wafra had alleged that Smithburg and Walter were “contro! persons” involved in the
day-to day management of Prime and that the.two men were involved in the preparation of the
financial statements, including the 1997 and 1998 annual 10-Ks containing the allegedly false
and misleading statements. Although she found that the complaint satisfied the who, what and
when elements, Judge Bucklo held that Wafta had failed to allege that Smithburg’s and Walter’s
signature on and implicit approval of the 10-K reports was false. Specifically, Judge Bucklo
found that Wafra had not made any “allegation that they knew, or ever should have known about
the kiting scheme that the 10-K reports failed to disclose.” Wafra II, 204 F.Supp.2d at 1126.
Judge Bucklo observed that Wafra’s allegations that “Smithburg and Walter were merely
involved in the day-to-day operation of Prime is insufficient to plead the ‘how’ of the fraud under
Rule 9(b). Jd. Accordingly, Judge Bucklo dismissed the ICFA claim as to Smithburg and
Walter.

E. Second Amended Complaint

In an attempt to cure the defects noted by Judge Bucklo in Wafra I and Wafra II, Wafra
filed a Second Amended Complaint. Specifically, Wafra amended count eight -- for securities
fraud violations against KPMG -- to include a specific misrepresentation in KPMG’s May 4,
1999 Letter. (R. 89-1, Second Am. Compl., 49 151-159.) Wafta also amended count ten, adding
an allegation that Smithburg and Walter “knew or, in the alternative, should have known about
Prime’s Diversion, Misappropriation and Kiting scheme.” (/d. 100.) Finally, Wafra added a
count eleven, alleging that KPMG violated Section 10(b) and Rule 10b-5 but raising an

alternative theory of liability.


information in the complaint. However, we will not consider additional information in the
response that is inconsistent with the complaint, expands the plaintiff's case, or concerns new
claims and new topics.”).

Smithburg and Walter correctly note that conclusory allegations without any factual
support are insufficient to satisfy the demands of Rule 9(b). See Robin v. Arthur Young & Co.,
915 F.2d 1120, *1127 (7" Cir, 1990) (“Plaintiffs must provide more than conclusory allegations
to satisfy rule 9(b)’s requirement that the ciréiimstances of the fraud be pleaded with
particularity”). But here, Wafra has offered more than bold, unsupported allegations.

Watra alleges that both Walter and Smithuburg were members of Prime Capital’s Board
of Directors. In addition, Walter served on Prime Capital’s Board’s Executive Committee and
the Proxy Committee from 1998 until 2000. (See R. 89-1, Pl.’s Reply in Opp. to Defs.’ Opp. to
Mot. for Leave to File Second Am. Compl., Ex. A.) Smithburg served on Prime Capital’s Board
and was a member of its Audit Committee, Executive Committee, Proxy Committee and
Compensation Committee at times relevant to the complaint. (/d.) The Audit and Executive
Committee allegedly had critical roles in oversééing Prime Capital’s business and accounting
practices, including “reviewing the methods uséd and examinations made by the auditors in
connection with the Company’s published financial statements.” (/d.) Thus, the Second
Amended Complaint and the exhibits attached to Wafra’s opposition to the motion to dismiss,
allege that Smithburg and Walter knew or should have known about the kiting scheme that the
10-K reports failed to disclose.

Accordingly, Smithburg and Walter’s motion to dismiss count ten is denied.

21


remain separate from any other fund and be turned over to the securitization trustee within two
business days. (/d.) The securitization docuriients further required Prime to instruct all payers on
the financial contracts to make payments directly to the lock-box account, and if payments were
misdirected, Prime was required to turn them over to the lock-box account within two business
days. (Id. § 28.) The money in the lock-box account was the property of the SPVs, not Prime,
and was to be used for payment on the investors’ notes. (/d.)

Wafta alleges that commencing in at least 1997 Prime began diverting and
misappropriating a large portion of rent payménts belonging to the SPVs by holding the funds for
more than two days and commingling these funds with its own. (R. 89-1, Second Am. Compl.,
4] 29-30.) This diversion allegedly resulted in.shortfalls of money required to be deposited in the
lock-box account for the benefit of the SPVs. a) Because of this shortfall, Prime allegedly
kited misdirected funds from the next month’s réceipts to pay its investors, which created a
shortfall for the next month as well. (/d. 29.) Watfra alleges that the diversion and
misappropriation raised an inference that Primé was insolvent, and that it hid this fact from
investors by kiting misdirected payments from the following month. Furthermore, the diversion
precluded the SPVs from making monthly payments to the noteholders. (Id. 32.)

The focal point of the Second Amended.Complaint is the 1999-A securitization in which
Wafra invested. This securitization closed on May 4, 1999. (R. 89-1, Second Am. Compl.,
136.) Wafta alleges that Prime Capital sold the 1999 financial contracts to two bankruptcy-
remote SPVs that were owned and controlled by Prime Capital -- PFC-A-1 and PFC-A-2. (id.
35.) Wafra claims that it relied on financial information from the 1997 10-K (audited by

KPMG) because the 1998 10-K and corresponding financials had not been issued yet. (Id.


the statements contained in the audit report were true. There can be no “violation” under the duty
to correct theory until it was “revealed by subsequently discovered information” that the 1997
audit report contained a material misrepresentation. Cf Stransky,51 F.3d at 1332. However,
Wafra alleges that if KPMG did not know of the misrepresentation at the time it issued the 1997
audit report, KPMG became aware of the misrepresentation at some time between September
1998 and May 4, 1999. Because Wafra alleges that the duty to correct was triggered sometime
after September 1998, its lawsuit, filed less than three years later in June of 2001, does not run
afoul of the statute of repose.’
2. Scienter

KPMG also argues that KPMG has failed to plead with particularity the element of
scienter. Under Section 10(b), scienter is either “the intent to deceive, manipulate or defraud”,
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976), or the “reckless disregard for the truth of
the material asserted.” SEC v. Jakubowski, 150.F.3d 675, 681 (7" Cir. 1998). Because Wafra
claims a securities fraud violation, both the heightened pleading requirements of Federal Rule of
Civil Procedure 9(b) and the Private Securities Litigation Reform Act (“PSLRA”) apply.

Rule 9(b) requires that a plaintiff plead “the circumstances constituting fraud . . . with

particularity.” See Jn re HealthCare Compare Corp. Sec. Litig., 75 F.3d 276, 281 (7" Cir. 1996).

> KPMG?’s reliance on In re Westinghouse Sec. Litig., 832 F.Supp. 989 (W.D. Pa. 1993), is
misplaced. As Wafta points out, Westinghouse.involved a derivative lawsuit under Section 14(a)
of the Exchange Act, not a Section 10(b) claim. “Section 14(a) does not require proof of scienter;
instead, a violation occurs under Section 14(a) “when the false or misleading proxy statement is
issued,” regardless of whether the individual filing the proxy statement knew it was false or
misleading. Jd. at 999. Thus, any duty to correct theory upon knowledge of the false or
misleading statements would not change the date. of the violation. In contrast, a Section 10(b)
claim requires scienter, and, thus the violation does not occur until the scienter element exists.

14


expressed by Judge Castillo in Chu v. Sabratek Corp., 100 F.Supp.2d 815, 823 (N. D. Ill. 2000).
Judge Castillo explained:

[T]he PSLRA’s only requiremént is that the facts alleged must give rise to

a “strong inference” of the defendant’s scienter. The types of facts with

which a plaintiff pleads scienter factor little into our analysis, as long the

overall facts give rise to a “a strong inference” of scienter. Thus, a

plaintiff may use “motive and opportunity” or “circumstantial evidence” to

establish scienter under the PSLRA, as long as those facts support a strong

inference “that the defendant acted recklessly or knowingly.”
Id., at 823. Thus, this Court will view the scienter allegations in the Second Amended Complaint
in light of the plain language of the statute.

It is clear that mere allegations that a defendant violated accounting standards such as

GAAS and AICPA are generally insufficient, standing alone, to create a strong inference of
scienter, See, e.g., Geinko v. Padda, 2001 WLi 163728, at *4 (N.D. IIL Sept. 28, 2001). Such
violations, however, are relevant in proving s¢iénter “when the complaint also identifies ‘red
flags,’ or 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.” Riggs
Partners, LLC. v. Hub Group, Inc., 2002 WL 31415721, at *9 (N.D. Ill. Oct. 25, 2002). In the
context of outside auditors, recklessness means that “the accounting firm practices amounted to
no audit at all, or to an egregious refusal to see the obvious, or to investigate the doubtful, or that
the accounting judgments which were made were such that no reasonable accountant would have
made the same decisions if confronted with the.same facts.” Jn re First Merchants, 1998 WL
781118, at *10 (N.D. Il. Nov.4, 1998) (citing SEC v. Price Waterhouse, 797 F.Supp. 1217, 1240
(S.D.N.Y. 1992)).

Watfra’s allegations in count eleven are prémised on the theory that KPMG did not have

16


were wholly owned subsidiaries of Prime Capital. (Jd. 4% 9-10.) Defendant KPMG served as
auditor for Prime Capital and its affiliates. (/d. 11.) Defendant William Smithburg was a
member of Prime Capital’s Board of Directors and the Board’s Executive and Audit Committees.
(Id. { 17.) Defendant John Walter was a metiiber of Prime Capital’s Board of Directors and the
Board’s Executive Committee. (Id. § 18.) Wafra alleges that both Smithburg and Walter
“exercised control over the general operations of Prime and had the ability and power to direct
and prevent the fraudulent conduct and statements of Prime at issue in this Complaint.” (/d.

19 17-18.)

Prime Capital is a specialty finance company that originated and serviced financial
contracts including equipment leases, loans and installment purchase agreements. From 1993 to
1999, Prime securitized its financial contracts to raise capital. Prime Capital formed special
purpose vehicles (“SPVs”) to which it transferred a pool of financial contracts. (R. 89-1, Second
Am. Compl., { 22.) The financial contracts consisted of equipment leases, loans and installment
purchase agreements. (/d. § 22.) The SPVs, in turn, would issue and sell promissory notes to
third parties using the financial contracts as collateral. (id. § 22.) The proceeds from the
financial contracts were used to make payments of principal and interest on the promissory notes.
da.)

Under this arrangement, Prime Leasing sérviced the financial contracts, including the
pursuit of delinquent accounts. (R. 89-1, Second. Am. Compl., { 23.) Prime Leasing was
authorized to act on behalf of the SPVs for the ptirpose of enforcing their rights and discharging
their obligations in connection with such assets. .(/d.) The securitization documents allegedly

required that all rent payments on the financial contracts be deposited into a lock-box account,


IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF ILLINOIS
EASTERN DIVISION NOV 2 6 2002

WAFRA LEASING CORPORATION 1999-A-1,

Plaintiff, No. 01 C 4314

)

)

)

)

v. ) Judge Amy J. St. Eve

)

PRIME CAPITAL CORPORATION, PRIME...)

LEASING CORPORATION, PRIME FINANCE _ )

CORPORATION 1999-A-1, PRIME FINANCE... )

CORPORATION 1999-A-2, KPMG LLP, )

BISCHOFF & SWABOWSKI, LTD., MARK )

BISCHOFF, JAMES FRIEDMAN, VERN )

LANDECK, THOMAS EHMANN, WILLIAM)

SMITHBURG and JOHN WALTER, )
)
me)

Defendants.

MEMORANDUM OPINION AND ORDER

Defendant KPMG has moved to dismiss counts eight and eleven of the Second Amended
Complaint. Defendants Smithburg and Walter,pave moved to dismiss count ten of the Second
Amended Complaint. For the reasons set forth below, Defendant KPMG’s motion is granted in
part and denied in part, and Defendants Smithburg and Walter’s motion is denied.

FACTUAL BACKGROUND

A. General Background

Plaintiff Wafra Leasing Corporatin 1999-A-1 is a Cayman Islands corporation that was
formed for the purpose of holding securities investments issued by Defendants. (R. 89-1, Second
Am. Compl., | 7.) Defendant Prime Capital Corporation, is a Delaware corporation. (/d., J 8.)

Prime Leasing, Inc., Prime Finance Corporation 1999-A-1, Prime Finance Corporation 1999-A-2

\e


outlined in the May 4 Letter or that it took responsibility for the sufficiency of the procedures.
Thus, Wafra could not have reasonably relied on KPMG’s representations in the May 4 Letter?

B. Count Eleven -- An Alternate Theory of Securities Fraud

With count eleven, Wafra alleges in the alternative that KPMG had a duty to correct its
1997 audit but failed to do so. Specifically, Wafra alleges that even if KPMG believed that the
statements contained in its audit report on the,financial statements included in the 1997 10-K.
were truthfull at the time they were made, KPMG learned prior to the issuance of the May 4
Letter that the statements were misleading and deceptive but failed to correct them. Wafta
further alleges that KPMG knew that it was relying on these 1997 statements in making its
decision whether to invest in the 1999-A Secutitization.

KPMG argues that count eleven fails to state a claim under Section 10b-S because the
claim is barred by the statute of repose. Judge Bucklo found in Wafra / that the statute of repose
period commenced on March 27, 1998 when KPMG issued its audited financials, and KPMG
suggests that a duty to correct does not delay the running of this repose period. KPMG further
contends that Plaintiff failed to plead scienter with particularity.

1. Statute of Repose

The relevant statute of repose provides that a Section 10(b) and/or Rule 10b-5 claim must
be commenced within three years after the violation. Lampf, Pleva, Lipkind, Prupis &
Petigrow v. Gilbertson, 501 U.S. 350, 364, 111 S.Ct. 2773, 2782 (1991). The Supreme Court in

Lampf, however, did not define what constitutes the “violation” for purposes of the statute of

> Because Wafta could not reasonably have relied on the representations in the May 4 Letter, the
Court need not address the sufficiency of Wafra’s allegations of misrepresentations or scienter in
count eight.

12


As explained by the Seventh Circuit, “this méans the who, what, when, where, and how: the first
paragraph of any newspaper story.” DiLeo y. Ernst & Young, 901 F.2d 624, 627 (7 th Cir.1990).
This particularity mandate requires “the plaintiff to conduct a precomplaint investigation in
sufficient depth to assure that the charge of fraud is responsible and supported, rather than
defamatory and extortionate.” Ackerman v. Northwestern Mut. Life Ins. Co., 172 F.3d 467, 469
(7 Cir. 1999). The particularity requirements of Rule 9(b), however, do “not require
‘particularity’ with respect to the defendants’ mental state.” DiLeo, 901 F.2d at 629. Instead, the
allegations in the complaint need only “afford_a basis for believing that the plaintiff[] could prove
scienter.” Id. See also Caremark, Inc. v. Coram Healthcare Corp., 113 F.3d 645, 650 n.7 (7"
Cir. 1997). The PSLRA also imposes heightened pleading requirements for scienter.
Specifically, the PSLRA requires that a plaintiff “state with particularity facts giving rise to a
strong inference that the defendant acted with the required state of mind.” 15 U.S.C. §
78u-4(b)(2).

The Seventh Circuit has not yet addressed the the heightened pleading requirement for
scienter under Rule 9(b) and the PSLRA. Several courts in this district have followed a standard
adopted by the Second Circuit, which requires that a plaintiff allege either: (1) facts showing that
the defendants had both motive and opportunity to commit fraud; or (2) facts constituting strong
circumstantial evidence of conscious misbehavior or recklessness. See, e.g., Riggs Partners,
LLC. v. Hub Group, Inc., 2002 WL 31415721, at *4 (N.D. Ill. Oct. 25, 2002); Lindelow v. Hill,
2001 WL 830956, at *6 (N.D. Ill. July 20, 2001)... See also Press v. Chemical Investment Serv.
Corp., 166 F.3D 529, 538 (2 Cir. 1999) (citations and quotations omitted). Although the

Second Circuit’s standard is instructive, this Court declines to adopt that standard for the reasons

15