Securities Law Liability

Liability Under Securities Law

A U.S. district court ruled that an accounting firm was not liable under federal securities laws for misrepresentation in a company’s financial statements. In 1993, Ernst & Young client Cygne Designs, a clothing manufacturer, announced the acquisition of another clothing manufacturer in exchange for Cygne stock. It publicly represented that this acquisition would increase its earnings and profitability. The goodwill from the acquisition, which closed in April 1994, was booked at approximately $47 million.

Notwithstanding Cygne’s favorable public representations regarding the acquisition, the plaintiffs—Cygne investors—claimed that Cygne and the firm had learned during a due diligence review (before the acquisition) that the purchased company was experiencing problems, so there was no reasonable basis to believe the purchase price or the booked goodwill could be recovered. The plaintiffs asserted section 10(b) and rule 10b-5 (of the Securities Exchange Act of 1934) claims against the firm based on Cygne’s 1993 and 1994 financial statements. The plaintiffs said that the firm had fraudulently issued “clean” audit opinions on the statements despite its knowledge of facts that revealed the falsity of the statements.

In response to the complaint, the firm filed a motion to dismiss pursuant to rules 12(b)(6) and 9(b) of the 1934 Act. In support of its rule 12(b)(6) motion, the firm successfully asserted that the general allegations of GAAP and GAAS violations failed to satisfy the scienter requirements of section 10(b) and rule 10b-5. (The scienter requirements can be satisfied by demonstrating specific facts: (1) showing a motive for committing fraud and clear opportunity for doing so and (2) indicating conscious or reckless behavior by the defendants.) District Court Judge Kram agreed with the holding in SEC v. Price Waterhouse (797 F. Supp. 1217 [S.D.N.Y. 1992]) that the mere misapplication of accounting principles by an independent auditor does not establish scienter . A plaintiff must prove that the accounting practices were so deficient that the audit amounted to “no audit at all” or that the accountant’s judgments were such that no reasonable accountant would have made the same decisions if confronted with the same facts. In Judge Kram’s opinion, for the plaintiffs’ claims of purported GAAP and GAAS violations to be actionable, the plaintiffs would have had to allege that the firm’s alleged violations were the result of intentional deceit or that they rose to the level of recklessness.

The judge said the complaint also failed to comply with the pleading requirements of rule 9(b). In his opinion, a plaintiff can satisfy the Second Circuit’s standard for alleging facts (see SEC v. Price Waterhouse , above) that give rise to a strong inference of fraudulent intent in two ways: (1) by alleging facts demonstrating a motive for committing fraud and a clear opportunity to do so or (2) by identifying circumstances indicating conscious or reckless behavior by the defendant. The plaintiffs failed to satisfy either element.

The judge said the complaint contained no allegations of motive and no suggestion that the firm had received anything but its usual fees: The mere receipt of compensation and the maintenance of a profitable professional relationship did not constitute sufficient motive for purposes of pleading scienter .

According to Judge Kram, a contrary finding would require the assumption that the firm willingly condoned Cygne’s fraud in order to preserve its fee, at the risk of jeopardizing its reputation and license and the possibility of huge damages. Because this conduct would be economically irrational, the judge said he could not credit these allegations, citing the case of Shields v. Citytrust Bankeom, Inc ., (25 F3d 1124 [2d Cir. 1994]). In so doing, he acknowledged that he was disagreeing with decisions holding that the receipt of professional fees provided a sufficient motive for the purpose of pleading scienter . (See In re Leslie Fay Cos., Securities Litigation , 835 F. Supp. 167 [S.D.N.Y. 1993]).

Judge Kram also decided the plaintiffs had failed to allege facts that constituted evidence of recklessness: When motive is not alleged and the plaintiff relies entirely on allegations of recklessness in alleging scienter , the evidence presented must be proportionately greater than if motive is alleged. The claim that the firm knew or recklessly disregarded adverse facts about the acquisition was insufficient because the claim was based solely on the firm’s status as auditor and the plaintiffs offered no specific facts about how or when the firm learned of—or recklessly disregarded—the problems associated with the acquisition. For instance, the plaintiffs never said what alleged information was revealed to the firm, in what form the information was provided, at what point the firm became aware of it and from whom the firm received this information. Thus, Judge Kram concluded the claim was insufficient under the requirements of rule 9(b) as well. ( Zucker v. Sasaki , CCH Securities Law Reporter, ¶99,493, U.S. District Court for the Southern District of New York, no. 95 Clv. 10517 [SWK])

—Edited by Wayne Baliga, CPA, JD, CPCU, CFE
president of Aon Technical Insurance Services .

©1998 AICPA