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Audit Firm Frazer Frost Must Face Allegations Over RINO Fraud

Friday, August 30, 2013

The U.S. District Court for the Central District of California Aug. 1 declined to dismiss putative class securities fraud claims over outside auditor Frazer Frost LLP’s alleged role in client RINO International Inc.’s (RINO) wide ranging fraud in its China-based industrial equipment business (Hufnagle v. RINO Int'l Corp., C.D. Cal., No. CV 10-08695 DDP (VBKx), 8/1/13).

Judge Dean D. Pregerson said that the question now before the court is “' When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?’” (See, Tellabs, Inc. v. Makor Issues & Rights, Ltd, 551 U.S. 308 (2007)).

Viewed as a whole, the court wrote, the totality of the allegations supports an affirmative answer. As relevant here, the court said that a third amended complaint, or TAC, alleged that RINO “engaged in a wide-ranging fraud regarding its industrial equipment business in China.” The court noted, without further discussion, that under a settlement agreement, the plaintiff has dismissed all claims against all defendants, “with the exception of Frazer Frost.” 

Allegations 'Viewed as Whole.'

In this ruling, the court denied Frazer Frost’s motion for dismissal.

In so ruling, the court said that various irregularities, “though insufficient to establish” the requisite element of scienter on their own, “more readily support an inference of wrongdoing when viewed as a whole, alongside other allegations.”

For example, the court said that Frazer Frost allegedly knew that the revenue and profit numbers reported on RINO’s tax returns did not match the figures reported to investors. “These are not the only allegations that might give rise to suspicions,” the court remarked. It pointed out that the TAC alleges that RINO claimed a 100 percent income tax exemption in 2008.

Further, by the end of 2008, RINO had allegedly advanced $22 million in cash to two of its major suppliers of raw materials. In 2009, the court added, 93 percent of RINCO’s purchases, or over $79 million, allegedly came through these two suppliers alone. The court said that one of these two suppliers was owned by the nephew of RINO’s chief executive officer, and had no phone number or website. Nor did the larger of the two suppliers, which was owned by RINO’s CEO’s mother, the court noted.

RINO was also “generous to the CEO himself,” allegedly providing him an interest free unsecured loan of $3.5 million for the purchase of a personal residence in California. 

Dismissal Bid Fails

The court determined that the plaintiff sufficiently alleged scienter and that Frazer Frost’s motion to dismiss must be denied. The court said that allegations of tens of millions of dollars in cash “to a small number of shadowy suppliers, a claimed 100 percent income tax exemption, millions of dollars in unsecured loans to corporate officers, wildly divergent revenue and profit figures,” and other factors provide “far more support to the inference that Frazer Frost knowingly or recklessly approved RINO’s fraudulent financial statements than to the competing inferences that RINO’s figures were the result of “China’s tax rules, innocent misapplication of accounting methods, or standard business practices.”

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