Auditor's Liability for Securities Violations
T he U.S. Court of Appeals for the Ninth Circuit ruled that an audit firm preparing a fraudulent audit report that it knew would be included in its client's annual 10-K filing with the Securities and Exchange Commission may be held liable as a primary violator of the Securities Exchange Act of 1934. This case began in November 1990 when Ernst & Young prepared and issued an allegedly false and misleading audit opinion for its audit of Community Psychiatric Centers (CPC), a publicly traded corporation. The shareholders alleged the firm had failed to disclose that the corporation had a major accounts receivable problem. They further alleged the firm knew the audit opinion would be included in the 10-K. Shareholders sued the firm after the corporation's stock plummeted in September 1991 with the announcement of a major drop in earnings attributed to $37 million in uncollectible debt.
The plaintiffs' class action alleged the firm had produced a fraudulent audit report with the knowledge that the client would disseminate the report to the securities market. As a consequence of these actions, the firm allegedly committed fraudulent acts in connection with the trading of securities and thus violated section 10(b) of the 1934 act. The plaintiffs further claimed the firm was both a primary violator of section 10(b) and a secondary violator as a conspirator and aider and abettor to CPC. The district court granted the firm's motion for summary judgment on all counts. The court held an independent accounting firm does not act "in connection with" securities trading when it produces a fraudulent audit report that it knows its client will include in a 10-K. The plaintiffs appealed.
On appeal, the Ninth Circuit reversed and remanded the district
court's grant of summary judgment. The court rejected the firm's
argument that section 10(b) limits liability to only those who
actually trade securities. In analyzing the 1934 act, the court noted
the act was designed to protect investors from manipulation of stock
prices. The "traders-only" rule proposed by the firm is
inconsistent with the act's goals. It would exempt from section 10(b)
a broad range of misinformation and market manipulation, as long as
the perpetrators did not buy or sell securities in connection with
their activities. A party that introduces fraudulent information into
the securities market does no less damage to the public because it
does not trade stocks. Therefore, the act's goals are better served by
giving section 10(b) its natural meaning and imposing liability on all
whose false assertions are reasonably calculated to influence the
investing public. ( McGann et. al. v. Ernst &
Young , 96 C.D.O.S. 6719)
A court of appeals in Florida ruled that notice of a potential claim, as opposed to an actual claim, was sufficient notice under the accountant's professional liability insurance policy. This case began when the accounting firm purchased primary and excess insurance policies for the period August 31, 1984, to August 31, 1985. These policies were "claims-made policies," which required that claims be reported during the policy period in order for coverage to apply for the claim. The accounting firm also purchased extended reporting coverage, extending this reporting period to October 1, 1990. In 1987, the accounting firm was sued for malpractice. These claims arose from a series of failed tax shelter investments recommended by the firm to its clients.
In January 1990, the insurer wrote to the firm and noted that its extended reporting coverage would expire on October 1, 1990. It asked the firm to furnish a list of any other clients who might sue the firm for its role in recommending the failed tax shelters. The firm responded in September 1990, listing more than 700 parties who might still sue. The firm reported these matters as claims under the policy. After the extended reporting period expired in October 1990, 3 of the 700 listed parties filed suit against the firm. The insurer denied coverage for these claims, saying that the firm's September 1990 letter reported only potential claims, and the policy required the reporting of actual claims. The firm sued the insurer for coverage for these claims.
Both the trial and appellate courts ruled in the firm's favor. The appellate court noted that the policy defined "claim" broadly to include potential claims. The court further stated that the firm's September 1990 letter constituted sufficient notice of potential claims. The insurer did not object to this notice at the time or request additional information. Therefore, coverage was appropriate for the insured's claims.
This case points out the need for firms to fully report all claims and potential claims to their insurance underwriter as soon as they have enough facts to determine an action may result. Failure to do this may lead to the claim's denial. ( United States Fire Insurance Co. v. Fleekop , no. 95-1726, Fl. App. 10/30/96)
Editor's note: Thanks to Dennis Zaragoza for submitting the McGann case.
Edited by Wayne Baliga, CPA, JD, CPCU, CFE,
president of Aon Technical Insurance Services.