Second Circuit and Eleventh Circuit Courts of Appeal
Auditors are not always found guilty of negligence, gross negligence, and fraud when lawsuits are filed against them. And they do not always settle lawsuits to avoid costly, protracted litigation. A good example is legal action taken against three accounting firms in in re Advanced Battery Technologies, Incorporated and Ruble Sanderson v. Bagel, Josephs, Levine & Co., LLC, Friedman LLP, and EFP Rothenberg, LLP. For purposes of this case, Advanced Battery is referred to as ABAT and the three accounting firms simply as “the auditors.”
On March 25, 2015, the Second Circuit and Eleventh Circuit Courts of Appeal affirmed dismissals of securities fraud claims filed against the auditors that audited Chinese reverse-merger companies because the plaintiffs did not adequately plead scienter under the heightened pleading standard imposed by the Private Securities Litigation Reform Act of 1995.1 Under the PSLRA, plaintiffs must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind” with respect to each act or omission of the defendant that is alleged to violate the securities laws.
The Second Circuit’s opinion in ABAT stated that to allege scienter on a recklessness theory against an independent audit firm under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, a plaintiff must allege facts showing that the audit firm’s auditing practices were so deficient as to amount to “no audit at all” or that the audit firm disregarded signs of fraud that were “so obvious” that the audit firm must have been aware of them.
The ABAT ruling is significant because it is the first federal appellate case to expressly reject scienter arguments based on the alleged discrepancy between a company’s filings with the U.S. SEC and with China’s State Administration of Industry and Commerce (SAIC), a regulatory agency to which Chinese companies must submit financial statements as part of an annual examination.
The decision reflects a growing trend of courts rejecting securities fraud claims filed against independent audit firms in the context of Chinese reverse-merger companies. In ABAT, the plaintiffs alleged that the auditors falsely represented that they performed their audits in accordance with professional standards and that ABAT’s financial statements were fairly presented.
An amended complaint upon appeal of the lower court decision against ABAT alleged that the audit firms were reckless and committed an “extreme departure from the reasonable standards of care” by failing to identify several purported “red flags,” including: (1) conflicts between ABAT’s financial statements filed with China’s SAIC and with the SEC; and (2) the unreasonably high profits that ABAT reported in its SEC filings, in contrast to the significant losses that it reported in its SAIC filings. The district court denied leave to amend, and the Second Circuit affirmed
.2 The Second Circuit agreed with the district court that the proposed amended complaint, like the previous complaint, failed to adequately plead the audit firms’ scienter under the theory of recklessness and that amendment would be futile. The appellate court explained that the plaintiff was required to allege conduct “that is highly unreasonable, representing an extreme departure from the standards of ordinary care,” such that the conduct “must, in fact, approximate an actual intent to aid in the fraud being perpetrated by the audited company as, for example, when a defendant conducts an audit so deficient as to amount to no audit at all, or disregards signs of fraud so obvious that the defendant must have been aware of them.”
3 Much of the Second Circuit’s analysis focused on the plaintiff’s argument that the audit firms acted recklessly by failing to inquire about or review ABAT’s financial filings with China’s SAIC.
In rejecting these arguments, the court noted that none of the “standards on which [the lead plaintiff] relies—the Generally Accepted Auditing Standards, Statements on Auditing Standards, or GAAP [generally accepted accounting principles]—specifically requires an auditor to inquire about or review a company’s foreign regulatory filings.”
The court declined to adopt the general rule, urged by the plaintiff, that allegations of an audit firm’s failure to inquire about or review such foreign filings are adequate to plead recklessness under the PSLRA. Although the court noted that “such a legal duty could arise under certain circumstances” (which it did not explain), it concluded that those circumstances were not pled here.
In addition, the Second Circuit held that ABAT’s report of high profit margins in its SEC filings triggered, at most, a duty to perform a more rigorous audit of those filings, not of the company’s SAIC-China filings. The court declined to infer recklessness from the allegations that one of the audit firms had access to, and “presumably relied” on, the financial data underlying ABAT’s SAIC filings but failed to see that the data contradicted the company’s SEC filings.
Instead, the court found another inference more compelling—that ABAT maintained different sets of data for its Chinese and U.S. regulators and provided the audit firm with false data. The ABAT opinion is significant because it illustrates the high burden plaintiffs face in pleading recklessness in Section 10(b) cases against independent audit firms.
Notably, since under the PSLRA the plaintiffs filing suit must plead with particularity facts alleging that the audit firm’s work was so deficient as to amount to no audit at all, the historical legal standards for auditor liability seem to have turned in favor of the auditors.
Also, the Second Circuit’s determination that allegations that an audit firm failed to review AIC filings is not sufficient to meet this high burden for pleading scienter is significant, as such allegations are frequently pled in matters involving audits of the financial statements of Chinese companies listed on U.S. securities exchanges. ___________________ 1A reverse merger occurs when a privately-held Chinese company goes public in the U.S. by merging with U.S. publicly-traded “shell companies.”
The reverse merger trend was initially fueled by the difficulties of going public in China. Reverse mergers are often described as an inexpensive “back-door” way of taking a company public, but they have a sketchy history in the U.S. One reason is the publicly held shell company has virtually no assets or business of its own.
Many shell companies are the remnants of failed companies, though some are created from scratch for the single purpose of merging with an existing private company. 2 In re Advanced Battery Technologies, Incorporated and Ruble Sanderson v. Bagel, Josephs, Levine & Co., LLC, Friedman LLP, and EFP Rothenberg, LLP, 14-1410-cv, March 25, 2015, Available at: http://caselaw.findlaw.com/us-2nd-circuit/1695335.html. 3“2 cases audit firm defendants can rely on,” Law360, New York, April 9, 2015, Available at: http://www.law360.com/articles/640875/2-cases-audit-firm-defendants-can-rely-on.
The Second Circuit and Eleventh Circuit Courts of Appeal affirmed dismissal of securities fraud claims because the plaintiffs did not adequately plead scienter under the standard imposed by the Private Securities Litigation Reform Act of 1995. Scienter is defined as which of the following?
(a)The standard of reasonableness required of a prudent person in the management of his affairs
(b)An untrue statement of a material fact
(c)The intent to deceive, manipulate, or defraud
(d)The failure to maintain due diligence during the issuance of new securities known as an IPO
The requirements of the Act of 1934 often center on the liability of auditors under Section 10 and rule 10b-5. The provisions make it unlawful for a CPA to:
(a)make an untrue statement of an immaterial fact.
(b)employ a device, scheme, or artifice to enhance the statements.
(c)engage in any act, practice, or course of business to commit fraud.
(d)make an immaterial false or misleading statement.