Mixed results in Koss securities fraud suit

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The class action on behalf of shareholders of Koss Corp. may proceed, at least in part.

On Thursday, U.S. District Court Judge Lynn Adelman denied a motion to dismiss the claim against the corporation, as well as a separate claim against CEO Michael J. Koss, asserting “control person” liability under Section 20(a) of the Securities Exchange Act of 1934.

However, Adelman dismissed the Section 10(b) claims against Michael Koss and Grant Thornton LLP, the company’s accountants.

The case has its genesis in the embezzlement of more than $30 million from the corporation by Sujata Sachdeva, the company’s former vice president of finance, secretary and principal accounting officer.

When the embezzlement was discovered, Koss Corp. halted trading of its stock on NASDAQ. When trading resumed several weeks later, the share price had declined by approximately 24 percent.

David A. Puskala brought suit, alleging securities fraud and proposing a class of shareholders who purchased Koss stock in reliance on false information in the company’s SEC filings.

All the defendants, save for Sachdeva, moved to dismiss the complaint.

Koss Corp.

Addressing the motion by Koss Corp. first, Adelman denied it.

Koss Corp. argued it could not be liable, because Sachdeva lied to the SEC to conceal her individual acts of embezzlement, rather than to further the company’s goals.

However, as a high-ranking officer in the company, Sachdeva had apparent authority when she signed the SEC filings and represented that they were accurate. Accordingly, Koss Corp.’s motion to dismiss was denied.

Adelman explained, “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.”

Michael Koss

But the court did dismiss the Section 10(b) claim against Michael Koss, because the complaint failed to sufficiently allege scienter on his part.

Under 7th Circuit precedent, recklessness is sufficient to satisfy the scienter element under sec. 10(b). Sundstrand Corp. v. Sun Chem. Corp. 553 F.2d 1033, 1044-1045 (7th Cir. 1977).

But the court found that recklessness could not be inferred from the allegations in the complaint, notwithstanding the sheer size of the fraud, because of the lack of any plausible motive for Koss to aid in the fraud.

Adelman wrote, “Perhaps the size and duration of Sachdeva’s fraud gives rise to an inference that Michael Koss was negligent in failing to supervise the company’s accounting practices. But negligence is not recklessness.”

“[T]aking the lack of an explanation for recklessness into account,” Adelman concluded, “the innocent inferences must be deemed to be more compelling than the inference of scienter.”

Grant Thornton

For similar reasons, Adelman dismissed the claim against the accounting firm, Grant Thornton.

Adelman noted that, in the usual case where an accountant is guilty of securities fraud, he aids the company by using accounting practices that make the company look more profitable to investors than it really is.

Here, however, the allegation is that Grant Thornton merely failed to detect fraud that the company would have wanted to know about.

Dismissing the claim, Adelman reasoned, “considering the allegations against Grant Thornton collectively, the inference that Grant Thornton was reckless in certifying Koss’s financial statements is less compelling than the inference that Grant Thornton was merely negligent in failing to detect the fraud.”

Control person

But Adelman denied the motion to dismiss the sec. 20(a) claim against Michael Koss.

Section 20(a) provides that a person who “controls” any person liable under the securities laws is jointly and severally liable for the violation “unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.”

Because Koss Corp. can be held liable for fraud, and Michael Koss controlled the corporation as its CEO, the court held that the complaint stated a claim against him.

The court acknowledged that, if Michael Koss acted in good faith, he is not liable. But, because good faith is an affirmative defense, rather than an element of the plaintiff’s case, the court denied the motion to dismiss.

Adelman concluded, “While plaintiff has not pleaded facts giving rise to a strong inference that Koss acted recklessly, this does not affect the sec. 20(a) claim because … plaintiff is not required to plead facts negating the good-faith defense.”

Case: Puskala v. Koss Corp., No. 10-C-0041.

David Ziemer can be reached at [email protected].