May 18, 2007

Audited vs. Unaudited

From Lyle Roberts’ “10b-5 Daily” Blog: A recent decision by the U.S. Court of Appeals for the Second Circuit offers some interesting clarifications on the scope of accountant liability for securities fraud. In Lattanzio v. Deloitte & Touche LLP (2d Cir. Jan. 31, 2007), the court addressed whether Deloitte could be held liable for statements in audited and unaudited financial filings.

As to the company’s unaudited financial filings, the court found that Deloitte’s regulatory obligation to review the company’s quarterly statements did not turn those statements into accountant’s statements. Even if the public understood that Deloitte was engaging in these reviews, the accountant’s “assurances were never communicated to the public.” The court also rejected plaintiffs’ argument that the reviews created a duty to correct the quarterly financial statements if false and that a breach of this duty amounted to a misstatement by Deloitte. The court noted that there is a distinct difference between the duties and liabilities created by a review of interim financial statements and those created by an audit of annual financials.

As to the company’s audited financial filings, the court dismissed the relevant claims based on a failure to adequately plead loss causation. The court held that the “plaintiffs had to allege that Deloitte’s misstatements [in the company’s annual reports concerning accounts payable and inventories] concealed the risk of [the company’s] bankruptcy.” Given that Deloitte had issued a going concern warning – along with the disclosed (if understated) collapse in the company’s value – the risk of bankruptcy was apparent. Accordingly, the court found that the plaintiffs had not alleged facts showing that Deloitte’s misstatements were the “proximate cause of plaintiffs’ loss; nor have they alleged facts that would allow a factfinder to ascribe some rough proportion of the whole loss to Deloitte’s misstatements.”

Holding: Dismissal affirmed.

Quote of note: “Public understanding that an accountant is at work behind the scenes does not create an exception to the requirement that an actionable misstatement be made by the accountant. Unless the public’s understanding is based on the accountant’s articulated statement, the source for that understanding – whether it be a regulation, an accounting practice, or something else – does not matter.”

More on Auditor Liability

Recently, the Second Circuit reversed a lower court decision and held – in Overton v. Todman – that an auditor has a duty to correct prior certified opinions and may be held liable under Rule 10b-5 if it fails to do so. In other words, once an auditor knows their opinion is wrong, they ought to do something about it and tell people they should no longer rely on it. We have posted a copy of the opinion (and memos that analyze it) in our “Auditor Liability” Practice Area.

More specifically, the court holds that “an accountant violates the ‘duty to correct’ and becomes primarily liable under § 10(b) and Rule 10b-5 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.”

This case appears to be the first in the Second Circuit to hold that an auditor has such a duty and may be primarily liable under the federal securities laws. The Second Circuit noted that its holding did not conflict with Central Bank of Denver v. First Interstate Bank of Denver, the 1994 Supreme Court case which held that there was no secondary aiding and abetting liability under Section 10(b), as the auditor in Overton had acted in a primary capacity.

PCAOB Report: The Auditors’ Duty to Uncover Fraud

Way back in late January, the PCAOB issued a report that discusses auditors’ implementation of PCAOB interim standards regarding the auditor’s responsibility regarding fraud. The PCAOB issued the report to nudge auditors to be more diligent about their responsibilities vis a vis uncovering fraud and providing information that audit committees may find useful in working with auditors.

In the report, the PCAOB notes a number of deficiencies in the performance of audits, where audit procedures required to enhance the detection of fraud have not been performed, or have failed to measure up to professional standards, not unlike problematic audits of the past – and the report provides a list of areas for audit committees to probe the auditor on regarding how a particular audit is being conducted.

[I’m on the road for a few days so I took the liberty of posting some blogs I had drafted long ago but had never posted…plenty more of those in the cellar.]