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10-C0041 Puskala v. Koss Corp.

By: WISCONSIN LAW JOURNAL STAFF//July 28, 2011//

10-C0041 Puskala v. Koss Corp.

By: WISCONSIN LAW JOURNAL STAFF//July 28, 2011//

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Securities
Fraud

Investors in Koss may sue the corporation for securities fraud, but not the CEO or accountants; but it may sue the CEO asserting “control person liability under sec. 20(a).

“Here, Sachdeva was a senior corporate officer who made statements to the market while acting with apparent authority, and therefore the company is liable for her fraud even though she was not trying to further the company’s goals. Accordingly, the company’s motion to dismiss will be denied.”

“I am aware that courts have said that the absence of allegations establishing a motive to commit securities fraud is not necessarily fatal to a § 10(b) claim. See Tellabs, 551 U.S. at 325. Here, however, the absence of allegations establishing motive are fatal because plaintiff has pleaded no other facts supporting an inference of recklessness. Had plaintiff, for example, specifically identified dozens of obvious and serious flaws in Koss’s internal controls, then the lack of allegations establishing motive might not have required dismissal. But plaintiff alleges nothing other than the occurrence of the fraud itself, and to the extent the fraud’s occurrence can even be said to give rise to an inference of recklessness in the first place, that inference evaporates once we consider the lack of an explanation for Michael Koss’s alleged reckless behavior. Accordingly, the § 10(b) and Rule 10b-5 claim against Michael Koss must be dismissed.”

“Finally, as was the case with Michael Koss, plaintiff fails to show that Grant Thornton had a motive to behave recklessly. Plaintiff points to the fact that Grant Thornton earned more than $650,000 in fees from Koss, and he suggests that this gave Grant Thornton an incentive to overlook Koss’s accounting violations. But this suggestion is at odds with the fact that Sachdeva was using accounting violations to steal from Koss, rather than to help Koss defraud investors. The usual case in which an accountant’s receipt of fees is thought to provide a motive to overlook the company’s accounting fraud involves a company that is using aggressive or fraudulent accounting practices to make the company look more attractive to investors. In this situation, the accountant helps the company enrich itself at the expense of investors so that the company will continue to use the accountant’s services in the future. This line of reasoning has been criticized, see DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990), but in this case it makes no sense at all. Koss would have wanted Grant Thornton to detect Sachdeva’s theft (or a theft by any other employee), and so Grant Thornton’s reckless failure to be on the lookout for employee theft and accounting fraud would not have helped the company. If anything, Grant Thornton’s receipt of substantial fees from Koss makes it less likely that it would have behaved recklessly. It suggests that Grant Thornton would have wanted to perform a careful audit to ensure that the stream of fees continued. As it happened, Grant Thornton missed the fraud and was fired.”

“Michael Koss contends that plaintiff has pleaded facts triggering the good-faith defense by alleging that Koss ‘did not act with knowledge of Sachdeva’s fraud’ (Am. Class Action Compl. ¶ 80) and that the Koss board of directors – of which Michael Koss was a member – did not ‘begin to become aware of the problems in Koss’ internal controls and financial statements’ until Sachdeva’s embezzlement was discovered (id. at ¶ 107). The allegation that Michael Koss did not know of Sachdeva’s fraud is not sufficient to trigger the good-faith defense, since a controlling person can be liable if he is reckless in failing to prevent the primary violation. Donohoe, 30 F.3d at 912. As discussed above, plaintiff contends that Michael Koss was reckless in failing to ensure that the company’s financial statements did not contain misleading information. While plaintiff has not pleaded facts giving rise to a strong inference that Koss acted recklessly, this does not affect the § 20(a) claim because, as discussed, plaintiff is not required to plead facts negating the good-faith defense. Instead, because plaintiff has sufficiently alleged the elements of a prima facie case under § 20(a), plaintiff is entitled to gather additional facts during discovery, and in doing so he may uncover information undercutting the good-faith defense. Although this is something of a back door into discovery on the subject of Michael Koss’s scienter and thus seems like an end run around the PSLRA, it is allowed. See Makor Issues & Rights, Ltd. v. Tallabs, Inc., 437 F.3d 588, 605 (7th Cir. 2006); In re Nat’l Century Fin. Enters., Inc., 504 F. Supp. 2d 287, 304 (S.D. Ohio 2007) (‘The Court’s decision to allow the Section 20(a) claims to go forward but to dismiss the Section 10(b) claim reflects the scheme established by Congress. It has imposed a heightened pleading standard for a Section 10(b) claim but not for a Section 20(a) claim.’ (Internal quotation marks and citation omitted)).”

10-C0041 Puskala v. Koss Corp.

E.D.Wis., Adelman, J.

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