An influential federal appeals court has ruled for the first time that auditors can be liable under securities laws if they fail to correct false financial statements.
A trial judge had dismissed the suit, filed under Rule 10b-5 of the Securities Exchange Act, against an accounting firm, finding that the plaintiffs had failed to state a viable theory of recovery. But the New York-based 2nd U.S. Circuit Court of Appeals said the judge was wrong to conclude that the accountants didn’t face any liability.
An auditing firm can incur liability under the Exchange Act, the appellate court wrote, whenever it makes a statement in its certified opinion “that is false or misleading when made, subsequently learns or was reckless in not learning that the earlier statement was false or misleading, knows or should know that potential investors are relying on the opinion, yet fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements.”
McTamaney
“I can really see this as a Pandora’s box opening the next steps of liability for auditing firms,” says Robert McTamaney, of the law firm Carter Ledyard & Milburn. “It’s the next step that’s potentially very worrisome to auditors of public or private companies.”
Stanton
Emmett Stanton, a partner with the law firm Fenwick & West, says the ruling “suggests a willingness on the part of courts to broaden auditor liability. There may be areas where plaintiffs can push this.”
Increased auditor liability is the last thing Corporate America wants to hear about, since auditing firms already fear litigation so much (or so the critics say) that they require vast amounts of testing, evidence and documentation during audits—which leads to exorbitant compliance costs for laws such as Sarbanes-Oxley. The Committee on Capital Markets Regulation—more commonly known as the Paulson Committee, after Treasury Secretary Hank Paulson—made caps on auditor liability one of its key calls for reform; European accounting regulators are already proposing such caps as well (see related coverage in box at right).
Although auditors should be avoiding the types of practices alleged in the case, Overton v. Todman & Co., CPAs, Stanton says there are “also an awful lot of ‘head in the sand’ attitudes among auditors. It sometimes takes a well-publicized decision like this to cause people to rethink what their practices have been.”
James Moss, a partner with the Herrick Feinstein law firm, says the Overton ruling is “helpful for auditors because of its clarity—stating what auditors are required to do, and what they’re not obligated to do, in the way of going back and making a correction. If circumstances arise where it becomes clear that something fishy is going on, and in the past they have issued certifications and opinions that they knew the investing public would rely on, they have to correct them,” he says.
Payroll Inaccurately Reflected
Todman & Co., the accounting firm in Overton, audited the financial statements of Direct Brokerage, a broker-dealer registered with the Securities and Exchange Commission, from 1999 to 2002.
Each year, Todman issued its “unqualified” opinion that DBI’s financial statements accurately portrayed the company’s fiscal health. DBI filed its yearly financial statements, along with Todman’s certified opinions, with the SEC and the New York Stock Exchange.
RULING
An excerpt from Overton v. Todman & Co., CPAs follows.
This case requires us to examine one circumstance in which an accountant may incurprimary liability for securities fraud. Plaintiffs-appellants David Overton and Jerome I. Kransdorf filed this action against Todman & Co., CPAs (“Todman”), and its successor in interest, Trien, Rosenberg, Rosenberg, Weinberg, Ciullo & Fazzari, LLP, asserting a fraud claim under § 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5, and related state law claims. In a brief memorandum order, the District Court for the Southern District of New York dismissed the federal claim with prejudice for failure to plead a viable theory of primary liability and, as a result, dismissed the state law claims for lack of subject matter jurisdiction.
The precise issue on appeal is whether an auditor may incur primary liability under §20
10(b) and Rule 10b-5 when the auditor provides a certified opinion that is false or misleading when issued, subsequently learns or was reckless in not learning that the earlier statement was false or misleading, knows or should know that potential investors are relying on the opinion, yet fails to take reasonable steps to correct or withdraw its opinion and/or the underlying financial Further, on the facts now before us, we hold that an accountant need correct only those particular statements set forth in its opinion and/or the certified financial statements. Unless an accountant exchanges its role for the role of an insider, see Shapiro, 123 F.3d at 721, an
accountant is under no duty to divulge information collateral to the statements of accuracy and
financial fact set forth in its opinion and the certified financial statements, respectively. SeeCornfeld, 619 F.2d at 927.
…
Moreover, … we hold only that the duty to correct arises in the circumstances as pled in the securities claim now before us, specifically, when the accountant (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; and (3) knows or should know that potential investors are relying on its opinion. Under those circumstances, if an accountant fails to take reasonable steps to correct or withdraw its certified opinion and/or the underlying financial statements, it becomes primarily liable for a misleading omission under § 10(b) and Rule 10b-5, assuming all the other components of liability are present. We have no occasion to answer whether the duty to correct might arise in other circumstances.
…
[W]e conclude that the District Court erred in dismissingthe complaint. Plaintiffs pled that Todman’s certified opinion and DBI’s 2002 financial statements were misleading at the time they were issued, especially with respect to DBI’s payroll tax liability; Todman, inferably through its contacts with the forensic auditor hired by DBI, subsequently learned that its certified opinion was false; Todman also knew that DBI was soliciting outside investors based in part on its 2002 certified financial statements and Todman’s accompanying opinion; and that despite this knowledge, Todman took no action to correct or withdraw its opinion and/or DBI’s financial statements. These allegations adequately state a claim of primary accountant liability under § 10(b) and Rule 10b-5.
We further note that DBI’s status as a closely-held corporation in no way interdicts the
applicability of § 10(b) and Rule 10b-5. See 15 U.S.C. § 78(j) (“It shall be unlawful for any
person, . . . [t]o use or employ, in connection with the purchase or sale of any security registered
on a national securities exchange or any security not so registered, any manipulative or deceptive
device . . . .” (emphasis added)); Sulkow v. Crosstown Apparel Inc., 807 F.2d 33, 37 (2d Cir. 1986) (“The fact that Crosstown was a close corporation . . . is insufficient to negate the
character of the stock as a security.”); Golden v. Garafalo, 678 F.2d 1139, 1146-47 (2d Cir.
1982) (“[T]he Act has always been understood to apply to transactions in shares of close as well as publicly held corporations . . . .”); see also Shapiro, 123 F.3d at 718-19 (applying § 10(b) to“private placement” transactions effected between individuals and limited partnerships). Finally, defendants entreat us to examine the sufficiency of the pleadings in other respects, such as the adequacy of the allegations of scienter and loss causation. Because the District Court declined to reach those issues, and because plaintiffs have not yet had the opportunity to amend their complaint, we decline to address those questions now. Instead, “[t]he proper time and place for raising th[ese] point[s] is on remand before the District Court where, if need be, plaintiffs can be afforded an opportunity to replead.”
Source
Overton v. Todman & Co. (2nd U.S. Circuit Court of Appeals, No. 06-2496-cv; Decided Feb. 26, 2007).
Despite its certifications of accuracy, Todman allegedly made significant errors that concealed DBI’s largest liability. In 1998, payroll taxes were DBI’s largest single line item; its certified financial statements for that year reflected a payroll tax liability of $248,899. Yet in 1999, according to the complaint, DBI’s statements inaccurately reflected a payroll tax liability of zero. The errors in DBI’s financial statements ultimately came to light in early 2003. The resulting inquiries left the company in a “precarious financial position” by June 2003, the court said.
The lawsuit against Todman—filed by one of DBI’s large investors—claimed that by failing to correct its 2002 certified opinion, the auditor violated securities laws and damaged the plaintiff. The complaint charged that Todman recklessly audited DBI’s affairs and recklessly evaluated whether DBI could survive as an ongoing concern, despite “red flags” that allegedly cast serious doubt on the accuracy of DBI’s financial statements.
A judge dismissed the suit on the ground that Todman’s failure to correct its certified opinion simply was not “actionable under the federal securities laws.” But the 2nd Circuit—a highly influential court, since it includes New York—disagreed, finding that Todman had a duty to correct its certified opinion.
Specifically, the court found that an auditor violates its “duty to correct” and becomes primarily liable under Rule 10b-5 when it meets five conditions: “when it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied.”
Although the company in Overton was private, experts tell Compliance Week that the principles of potential auditor liability would have been the same if the company had been public.
Higher Audit Costs?
Gowen
George Gowen, a Philadelphia attorney who heads the law firm Cozen O’Connor’s securities and financial-services litigation practice area, says the case is notable because the court “squarely puts together” for the first time “two well-known principles in securities litigation: that auditors may be primarily liable for securities fraud for misstatements, and that liability can extend to the failure to correct old statements.”
Mariani
John Mariani, a partner with the law firm Gunster Yoakley & Stewart, says that the “broader ramifications may be whether or not down the road there might be a duty to update.” Plaintiffs’ lawyers, he notes, “are making efforts to expand liability toward all professionals that interact with the sale of securities—whether accountants, or lawyers, or underwriters, or whatever. They will look at this case in a favorable way because it’s extending liability to a point that had not been reached.”
Although larger accounting firms “will have processes in place to address these situations,” smaller auditing firms may have greater reason to be concerned that they could be exposing themselves to potential liability, says Thomas Dewey, a litigator with the Dewey Pegno & Kramarsky law firm. “It’s more of a question of making sure existing processes are up to the challenge rather than creating an entirely new capability.”
Wolf
And Rick Wolf, the former global compliance chief at Cendant and the president of compliance consulting firm Lexakos, says the ruling could lead auditors to incorporate more “language of disclaimer” in opinion letters, “to fend off reliance of putative investors on their opinion and statements such as that they will correct any inaccuracies if they become reasonably known after issuance of the certified opinion.”
Any “different level of scrutiny and analysis accountants undertake before signing off on opinions [would] only result in higher audit costs,” Wolf says.
Related documents, standards and coverage can be found in the box above, right.
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