United States District Court, M.D. Tennessee, Nashville Division
CAROLYN LYNN, individually and on behalf of all others similarly situated,
ARTHUR F. HELF, H. LAMAR COX, MICHAEL R. SAPP, FRANK PEREZ, and TENNESSEE COMMERCE BANCORP., INC., and KRAFTCPAs PLLC,
TODD J. CAMPBELL, District Judge.
Pending before the Court is Defendant KraftCPAs PLLC ("Kraft")'s Motion to Dismiss for Failure to State a Claim (Docket No. 65), to which Plaintiffs have filed a Response in opposition (Docket No. 75). For the reasons stated herein, Kraft's motion is GRANTED.
This case concerns the circumstances leading to the failure of Tennessee Commerce Bank (the "Bank") on January 27, 2012. Plaintiffs Carolyn Lynn and Grand Slam Master Capital Fund Ltd. ("Plaintiffs") seek to represent a putative class of plaintiffs who purchased common stock in the Bank's parent holding company, the Tennessee Commerce Bancorp, Inc. ("TNCC"), between April 18, 2008, and January 27, 2012 (the "Class Period"). On September 30, 2013, Plaintiffs filed a Second Amended Class Action Complaint ("SAC"), which asserts claims against TNCC, several former officers of TNCC (the "Individual Defendants"), and Kraft, which served as TNCC's and the Bank's independent outside auditor during the Class Period. With respect to Kraft, Plaintiffs assert a single count under § 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78a et seq, and 17 C.F.R. § 240.10b-5 ("Rule 10b-5") promulgated thereunder. Kraft has moved to dismiss this claim for failure to state a claim.
II. Background Facts
A. TNCC and the Bank
TNCC, which is headquartered in Franklin, Tennessee, acted as the holding company for the Bank. The Bank offered retail and commercial banking services to small- and medium-sized businesses in the Nashville area. Kraft acted as TNCC's independent external auditor from 2006 through the Bank's closure in January 2012.
According to the SAC, from about 2007 forward, TNCC systemically disregarded its own loan underwriting policies and guidelines, failed to implement sufficient "internal controls" to monitor and evaluate the Bank's loan portfolio for degradation in loan quality and credit risk, and disregarded regulations and laws concerning the recognition and mitigation of losses.
Notwithstanding the economic downturn that began in 2008, the Bank continued to issue increasingly risky loans in sectors of the economy that were impacted severely by the recession (construction and development, commercial real estate, and manufacturing, among others). Many of these loans were essentially uncollectible. By 2008, TNCC's concentration of commercial and industrial ("C&I") loans had reached 539% of total capital, while responsible peer entities were limiting their C&I portfolio to about 100% of total capital. To make matters worse, during the Class Period, the Bank originated more than $400 million in additional loans, growing its portfolio by about 40%, even as responsible peers were restraining their lending.
Even as the Bank continued to issue risky loans and failed to implement necessary internal controls, TNCC and the Individual Defendants reassured investors that the Bank's financial situation was actually improving (when in fact the opposite was true) and misrepresented the quality of its loan portfolio to investors. As discussed herein, an accounting term called the "allowance for lean and lease losses" (the "ALLL") approximates the portion of a lender's total loan portfolio that is impaired or otherwise not likely to be collected in the future. Discounting the present value of a loan portfolio by the ALLL provides a more accurate representation of a company's present financial status. Here, Plaintiffs allege that, from 2009 through 2012, the Bank intentionally understated its ALLL each year to disguise the Bank's actual worth and its increasingly dire financial prospects. As regulators later determined, by January 2012, when the Bank failed, more than 40% of the Bank's $1.0 billion in outstanding loans were uncollectible. In other words, at least as of the time the Bank failed, the ALLL was actually about $420 million, whereas the company had reported ALLL in August 2011 of just over $28 million.
During the Class Period, Kraft served as the external auditor for the Bank.
B. Alleged "Red Flags" of Financial Impropriety
Plaintiffs allege that Kraft failed to comply with GAAS when it stated, in its audit letters, that TNCC's financial statements complied with GAAP and were free of material misstatement. Plaintiffs allege that Kraft ignored numerous "red flags" of potential financial impropriety by TNCC and its officers. In particular, during the Class Period, the Federal Deposit Insurance Corporation ("FDIC") provided ongoing supervisory oversight of the Bank in compliance with federally mandated oversight requirements, in the course of which it identified potential problems at TNCC and the Bank. Based on materials in the record, relevant events include the following incidents:
2007: In July 2007, three members of TNCC's Board of Directors (the "Board") resign as a result of their disagreement with the Board's decisions concerning executive compensation. The FDIC does not take any action.
March-July 2008: In an April 2008 review, the FDIC notes an increase in the Bank's repossessed assets, some of which may have been held more than six months in violation of Tennessee law. The FDIC determines that the Board's Asset/Liability Committee ("ALCO")) has not been meeting on a regular basis and submitted false "minutes" to the Board, perhaps in violation of Tennessee criminal law. The FDIC also observes that the Bank's external audit (prepared by Kraft) contains two "material weaknesses" relating to the failure to follow policies relating to employee accounts and the failure of the asset liability committee to hold meetings. Notwithstanding these issues, the FDIC gives the Bank an overall satisfactory rating. In April 2008, Kraft issues an unqualified audit letter concerning the Bank's financial statements.
In April 2008, the FDIC performs a visitation to investigate allegations by the Bank's terminated CFO, George Fort, that the company had condoned or ignored misconduct by the Bank's employees and that the Bank had made inaccurate financial statements. Following the visitation, the FDIC declines to undertake formal supervisory action. The FDIC also determines that management has taken appropriate steps to correct the "weaknesses" identified in the 2007 external audit.
Nevertheless, Fort sues the Bank and TNCC in July 2008 for retaliatory discharge and breach of his employment contract. See Fort v. Tenn. Commerce Bancorp, Inc., Case No. 3:08-0668 (M.D. Tenn. July 9, 2008). In his lawsuit, Fort alleges that he raised concerns about the Bank's internal controls in 2007 and early 2008, including a February 2008 presentation to TNCC's Audit Committee disclosing that the Board's ALCO had been inactive and that members of the committee had been furnishing fraudulent meeting minutes to the Board and external auditors. Fort alleges that he informed TNCC in early March 2008 that he intended to speak with the FDIC immediately about his concerns, that he in fact spoke with the FDIC on March 6, 2008, and that he was terminated by the company on March 7, 2008 - allegedly in retaliation for speaking to the FDIC. The docket reflects that the parties settled the case and stipulated to its voluntary dismissal in October 2010, without any merits-based rulings from the court.
June 2009 Examination: After a June 2009 examination, the FDIC downgrades the Bank's composite rating and concludes that it is in "troubled condition." At the time, the FDIC notes that the economic downturn caused liquidity issues, that some evidence of lax underwriting and administration is present at the Bank, that it would be prudent for TNCC to reassess its risk appetite, and that the Bank's loan portfolio is highly sensitive to economic conditions.
January and February 2010: As a means of informal corrective action following the June 2009 review, the FDIC provides to the Board a proposed "Memorandum of Understanding" ("MOU") in January 2010. The MOU would require the board to, inter alia, develop a written plan to reduce its level of nonperforming assets, restrict advances to certain borrowers, and restrict asset growth. The Board pushes back: in February 2010, it asks the FDIC to consider the Board's earlier October 2009 Bank Board Resolution ("BBR") as a sufficient response to address the findings of the June 2009 examination.
April 2010: The FDIC performs a follow-up examination to assess the Board's compliance with the proposed, but unsigned, January 2010 MOU. On April 15, 2010, Kraft issues an unqualified audit letter in connection with the Bank's 2009 10-K filing, but notes that it was retained only to perform a financial statement audit, not a complete audit.
June 2010: The FDIC rejects the Board's proposal to treat the BBR as an appropriate response to the MOU. The FDIC informs the Board that the MOU reflects the most appropriate course of action. The Board does not sign the proposed MOU.
August 2010: The FDIC conducts an examination. The FDIC determines that the Bank's condition has deteriorated further: it concludes that earnings are insufficient to support operations, that liquidity is deficient, that the Bank continues to engage in lax lending practices with insufficient oversight or consideration of the potential consequences, and that management has not been recognizing losses in a timely manner, resulting in incorrect financial reports. Notably, the FDIC's final examination report does not issue until March 17, 2011.
February and March 2011: Based on the serious financial and managerial deficiencies identified in its August 2010 examination, the FDIC notifies the Board in February 2011 that it intends to pursue formal enforcement action.
On March 17, 2011, the FDIC provides its final August 2010 examination report to the Board. The report includes, inter alia, recommendations that the Bank (1) revise ALLL by $16.3 million, and (2) implement an ALLL calculation that complies with FAS 114 and FAS 5 methodology. On March 24, 2011 (one week later), the Board responds by challenging the FDIC's examination as significantly flawed, announcing that TNCC intends to appeal the results of the examination.
April and May 2011: On April 6, 2011, the FDIC informs the Board that it cannot appeal the grounds for the proposed enforcement action. On April 18, 2011, TNCC files its Form 10-K, which includes financial statements for fiscal year 2010. TNCC acknowledges the pending dispute with the FDIC concerning TNCC's calculation of "loan and loss impairment, " but TNCC states that the FDIC report of examination contains "various inaccuracies, " that TNCC "do[es] not concur" with the FDIC's preliminary recommendation to adjust ALLL by $16 million, and that TNCC intends to "vigorously appeal" the "various inaccuracies contained in the report of examination." In connection with TNCC's 2010 10-K, Kraft issues a qualified audit letter, stating that it was retained only to perform a financial statement audit and that it "cannot satisfy" itself concerning the ALLL, in light of the pending regulatory inquiries.
On May 25, 2011, the Board stipulates to the proposed order (the "Consent Order"). With respect to the ALLL, the Consent Order requires the Board to implement a reliable ALLL methodology going forward, but it does not require any adjustment to the 2010 ALLL.
June 2011: On June 1, 2011, Kraft issues an supplemental unqualified audit letter concerning the Bank's 2010 financial statements, again disclosing that it was engaged only to perform a financial statement audit.
September 2011: The FDIC conducts an examination to assess the Board's compliance with the Consent Order. The FDIC does not issue a final report before the Bank's closure. The FDIC orders the Bank to increase its ALLL by approximately $83 million.
November 2011: On November 1, 2011, the Bank issues a Restatement, stating that it will be revising its financial results for the second quarter of fiscal year 2011 ended June 30, 2011, to reflect an $83 million increase in the ALLL. The increased ALLL thereby decreases the Bank's capitalization to unacceptable levels.
January 2012: On January 20, 2012, the Bank files a Form 8-K/A with the SEC which includes a letter from Kraft stating that Kraft is withdrawing its 2010 audit letter and is investigating whether it will also withdraw audit letters corresponding to other previous financial statements by the Bank.
Unable to raise sufficient capital, the Bank is closed by the TDFI on January 27, 2012 and the FDIC is appointed as receiver.
C. Allegations Relating to Kraft
Plaintiffs allege that Kraft should be held liable for securities fraud because it failed to probe the reliability of the Bank's financial statements in the face of increasing "red flags" of likely financial impropriety. Plaintiffs' allegations and brief (as they relate to Kraft) take a "kitchen sink" approach, making it somewhat difficult to follow which statements Plaintiffs believe that Kraft should have amended, when, and in what manner. As best the Court can discern, Plaintiffs believe that Kraft should have realized at least by mid-2011 that TNCC had misstated the ALLL in its 2010 10-K and in the 10-K forms for previous years. The actual allegations of conduct by Kraft are sparse. In relevant part, Kraft performed a full audit relative to the 2007 and 2008 financials for the Bank, but it did not conduct an internal controls audit for fiscal years 2009 and 2010. The Bank failed in January 2012, well before TNCC's 2011 financial statements were due.
1. 2009 Audit Letter
In connection with TNCC's 2009 10-K filing, Kraft provided the following audit letter:
We have audited the accompanying consolidated balance sheets of Tennessee Commerce Bancorp, Inc. and subsidiaries (collectively, the "Company") as of December 31, 2009 and 2008, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tennessee Commerce Bancorp, Inc. and subsidiaries as of December 31, 2009 and 2008, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
We were not engaged to examine management's assessment of the effectiveness of Tennessee Commerce Bancorp, Inc.'s internal control over financial reporting as of December 31, 2009, in accordance with the standards of the Public Company Accounting Oversight Board, included in the accompanying Management's Report on Internal Control Over Financial Reporting and, accordingly, we do not express an opinion thereon.
2009 10-K at F-3 (emphases added).
Furthermore, in a section of the 10-K drafted and attested to by management, TNCC states:
Management, with the participation of the Corporation's Chief Executive Officer and Chief Financial Officer, conducted an assessment of the effectiveness of the Corporation's system of internal control over financial reporting as of December 31, 2009, based on criteria for effective internal control over financial reporting described in "Internal Control - Integrated Framework, " issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that the Corporation maintained effective internal control over financial reporting as of December 31, 2009.
This annual report does not include an attestation report of the company's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange ...