be offset by the benefits of earnings from the finished products.
(Compl. at ¶ 188(a).) Similarly, Padda represented to other
Sabratek shareholders that KPMG worked as a paid consultant on
the Unitron and GDS licensing agreements and that KPMG's
consulting advice in connection with those transactions was the
cause of the $39 million in accounting restatement announced on
October 7, 1999.
Moreover, according to a former Unitron employee familiar with
the events that led up to the signing of the "licensing
agreement" between Unitron and Sabratek, Sabratek informed
Unitron during the negotiations that it would not do the deal
"until its auditors [KPMG] signed off on it." Steven Holden,
Sabratek's CFO at the time, told Unitron management during
negotiations that any agreement would be submitted to KPMG for
its review, and that Sabratek "couldn't do the deal as a
licensing agreement until its auditors said it was kosher."
Holden thereafter informed Unitron that KPMG had in fact "signed
off" on the deal. (Compl. at ¶ 188(c).)
The plaintiffs also point to other factors that would have
caused all but the most reckless auditor to subject these
transactions to heightened scrutiny. When Sabratek signed the
licensing agreements with Unitron and GDS, the $7 million Unitron
deal and the $4 million GDS deal represented an overall 242%
increase in Sabratek's reported intangible assets. The decision
not to expense these deals as research and development expenses
effectively saved Sabratek's reported net income of $7.2 million
for 1997. (Compl. at ¶ 189(a).) Yet, Unitron was a developmental
stage company with no marketable products and virtually no
customers. Unitron's only major product, the MOON network system,
was only just entering the testing phase and was at least 18
months away from entering the market. (Compl. at ¶ 189(b).)
The magnitude of the fraud alleged combined with the allegation
that KPMG participated in structuring the suspect deals suggests
a deliberate ignorance or perhaps even knowledge on the part of
KPMG. In so concluding, we emphasize that this is still the
pleading stage of the case. Our decision today expresses no
opinion as to the truth of the allegations or the plaintiffs'
ability to produce evidence establishing the facts as alleged.
But, with respect to the plaintiffs' claim that KPMG fraudulently
certified Sabratek's financial statements about its intangible
assets, the allegations are sufficient to withstand KPMG's motion
III. Reliance of Sabratek Convertible Note Holders
KPMG finally argues that claims by the Sabratek convertible
note purchasers should be dismissed for failure to allege the
essential element of reliance. As KPMG contends, some form of
reliance or causal nexus is an essential element of a § 10(b)
cause of action. See Basic v. Levinson, 485 U.S. at 243, 108
S.Ct. at 489; Rowe v. Maremont Corp., 850 F.2d 1226, 1233 (7th
Cir. 1988). Without allegations of some causal connection between
the defendant's material misstatement and the plaintiff's injury,
the plaintiffs cannot survive a motion to dismiss. In the absence
of actual reliance, however, "an alternative method of
establishing causation — an effect on the market price" may
support recovery by plaintiffs who never actually read or relied
on the defendant's alleged misstatements. See Eckstein v. Balcor
Film Investors, 8 F.3d 1121, 1129 (7th Cir. 1993).
In addressing KPMG's arguments, we first conclude that the
plaintiffs have sufficiently pleaded actual reliance on KPMG's
misstatements. (Reply at 3.) Although the plaintiffs do not
explicitly state that they "received or read KPMG's audit
reports," (Reply at 7), the plaintiffs do specify that they
relied "directly or indirectly on the false and misleading
statements made by [KPMG]" and that because of KPMG's
misstatements, the plaintiffs
"acquired Sabratek's securities . . . at artificially high prices
and were damaged thereby." (Compl. at ¶ 212.) The plaintiffs
allege that they were ignorant of the falsity of KPMG's
statements and that they had erroneously believed them to be
true. (Compl. at ¶ 213.) Had the plaintiffs known Sabratek's true
financial conditions, which KPMG misstated, they "would not have
purchased or otherwise acquired their Sabratek securities."
(Id.) These allegations are sufficient to withstand KPMG's
motion to dismiss.
Further, contrary to KPMG's contentions, the plaintiffs have
pleaded sufficient facts to establish a rebuttable presumption of
reliance based on the fraud-on-the-market theory. KPMG contends
that because the plaintiffs have not pleaded that an efficient
market exists for Sabratek convertible notes, the plaintiffs are
not entitled to a presumption of reliance under the
fraud-on-the-market theory. (Mot. to Dismiss at 18). As explained
by the Supreme Court,
The fraud on the market theory is based on the
hypothesis that, in an open and developed securities
market, the price of a company's stock is determined
by the available material information regarding the
company and its business. . . . Misleading statements
will therefore defraud purchasers of stock even on
the purchasers do not directly rely on the
misstatements. . . . The causal connection between
the defendants' fraud and the plaintiffs' purchase of
stock in such a case is no less significant than in a
case of direct reliance on misrepresentations.
Basic Inc. v. Levinson, 485 U.S. 224, 241-42, 108 S.Ct. 978, 99
L.Ed.2d 194 (1988) (citation omitted).
The plaintiffs argue, and KPMG concedes, that "the question on
a motion to dismiss is not whether [the] plaintiff has proved an
efficient market, but whether he has pleaded one." Hayes v.
Gross, 982 F.2d 104, 107 (3d Cir. 1992) (emphasis added). KPMG
correctly notes that the complaint does not specifically allege
that Sabratek convertible notes were traded in an "efficient
market." (Mot. to Dismiss at 19.) The complaint does state,
however, that the notes were convertible into Sabratek common
stock, presumably at the will of the note holder, at a specified
dollar amount. (Compl. at ¶ 100.) The plaintiffs also explicitly
detail the existence of an efficient market for Sabratek common
stock. (Compl. at ¶¶ 201-02.) From these allegations, the Court
may infer the existence of an efficient market for Sabratek's
convertible notes. Millions of shares of Sabratek common stock
were traded on the Nasdaq National Exchange, and Sabratek was
followed by several securities analysts employed by major
brokerage firms. Inasmuch as there existed an efficient market
for Sabratek common stock, this Court also concludes that an
efficient market existed for Sabratek convertible notes, which
were convertible to Sabratek common stock.
Therefore, we conclude that Sabratek convertible note
purchasers have sufficiently alleged reliance and deny KPMG's
motion to dismiss their claim.
KPMG's motion to dismiss the plaintiffs' complaint, (R. 96-1),
is granted in part and denied in part as indicated herein. As
explained in Chu II, an amended complaint that conforms to this
opinion will be due on or before August 4, 2000.
A status hearing will be held in open court on August 9, 2000
at 9:45 a.m.