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Pleading Auditor Fraud After Tellabs
Law360, New York (April 16, 2009) -- On June 21, 2007, the Supreme Court in Tellabs
Inc. v. Makor Issues & Rights Ltd. clarified what it meant to plead sufficient facts giving
rise to a “strong inference” of scienter for the purposes of the Private Securities
Litigation Reform Act (“PSLRA”).
The court held that “to qualify as „strong‟ ... an inference of scienter must be more than
merely plausible or reasonable — it must be cogent and at least as compelling as any
opposing inference of nonfraudulent intent.”[1]
The court developed a three-part test for deciding securities fraud cases, directing
district courts to:
1) accept all factual allegations in the complaint as true;
2) consider the complaint in its entirety, i.e., “holistically,” and determine whether all of
the facts alleged, taken collectively, give rise to a strong inference of scienter; and
3) take into account plausible competing inferences.[2]
Prior to Tellabs, pleading auditor fraud was not an easy feat, and it was not uncommon
for a court to dismiss such cases.[3]
This is because courts recognized that a plaintiff‟s allegations must “overcome the
irrational inference that the accountant would risk its professional reputation to
participate in the fraud of a single client.”[4]
“[A] large independent accountant will rarely, if ever, have any rational economic
incentive to participate in its client‟s fraud.”[5]
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After the Supreme Court‟s ruling, however, it was unclear how the application of the
new Tellabs standard would affect courts‟ willingness to dismiss actions against outside
auditors.
Now, nearly two years after Tellabs was decided, the case law indicates that it has
become even more difficult to plead securities claims against outside auditors.
Indeed, a post-Tellabs review of the case law reveals a significant number of dismissals
against outside auditors,[6] as compared to only a few cases being allowed to go
forward.[7]
To demonstrate how the courts have implemented the Tellabs standard in auditor
cases, it is first important to discuss what Tellabs has not changed.
First, nothing in Tellabs altered the fact that courts continually apply a high standard for
pleading auditor recklessness. Because an auditor will rarely if ever have an incentive to
participate in a client‟s fraud, most if not all plaintiffs seek to establish scienter in
securities cases under the severe recklessness standard.
In the securities fraud context, however, many courts recognized, even before Tellabs,
that “the meaning of recklessness ... is especially stringent when the claim is brought
against an outside auditor.”[8]
Those courts contributed to the body of case law that held that recklessness on the part
of an independent auditor “entails a mental state so culpable that it „approximate[s] an
actual intent to aid in the fraud being perpetrated by the audited company.‟”[9]
It “requires more than a misapplication of accounting principles. The plaintiff must prove
that the accounting practices were so deficient that the audit amounted to no audit at all,
or an egregious refusal to see the obvious, or to investigate the doubtful, or that the
accounting judgments which were made were such that no reasonable accountant
would have made the same decisions if confronted with the same facts.”[10]
Courts post-Tellabs appear even more willing to apply this high standard for pleading
auditor recklessness.[11]
Second, despite the fact that courts are required to view the allegations in their entirety,
nothing in the application of the Tellabs standard has changed the fact that plaintiffs
cannot rely on boilerplate allegations to prove scienter, no matter how many such
allegations are made.
It was originally thought that the Tellabs “holistic” approach might render securities fraud
claims more plaintiff-friendly because plaintiffs might benefit from facts not pleaded with
particularity.[12] This has not proved to be the case in the auditor context.
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For example, post-Tellabs, courts continue to reject boilerplate allegations present in
almost any securities fraud case as evidence of scienter, including, among others: the
existence of GAAP and GAAS violations; the fact that an auditor has access to the
client‟s information; the existence of a restatement; the magnitude of the fraud; the fact
that an auditor received a substantial amount of fees for its services; and conclusory
allegations that red flags existed that should have put the auditor on notice.[13]
As the post-Tellabs case law demonstrates, the “holistic” approach has not been
interpreted as giving a green light to group a series of insufficient allegations together in
the hopes that, when taken collectively, they will be sufficient to plead scienter.
Plaintiffs must still plead particularized facts demonstrating what the auditor failed to do
or what the auditor knew and recklessly disregarded — a standard that proves difficult,
especially where such actions, taken collectively, must approximate the actual intent to
aid in a client‟s fraud.
The fact that Tellabs has not changed the standards that traditionally rendered pleading
auditor fraud difficult — the high standard for pleading auditor recklessness and the
inability of plaintiffs to rely on boilerplate allegations — places a premium on what
Tellabs has changed.
Tellabs now requires that courts take into account competing nonculpable explanations
for the auditor‟s conduct, a prong that generally weighs in favor of an auditor.
Commentators originally believed that the “dueling inferences” approach was likely to
increase unpredictability in securities fraud actions, a result the pleading standards of
the PSLRA were enacted to avoid.[14]
In the auditor context, however, the competing inferences requirement has enabled
auditors to better defend against securities class actions by permitting courts to take
into account not only the realities of conducting an audit, but also the conduct of the
client and its management.
Because an auditor is required to be independent, an outside auditor necessarily has
more limited information than corporate insiders,[15] and an auditor‟s job requires
complex and professional judgments.[16]
The competing inference that an auditor was negligent in making those judgments
based on the limited information it has will almost always be more compelling than the
inference that the auditor acted with the requisite scienter.
Moreover, Tellabs enables auditors to offer competing inferences based on the client‟s
conduct.
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Where an auditor is given false documents or lied to by company management, the
inference that the auditor, like the public, was deceived is rendered more compelling
than the competing inference that the auditor acted with the requisite recklessness.[17]
Simply put, the competing inference requirement allows auditor defendants to explain
complaint allegations in the context of the audit as a whole, providing auditor
defendants a better opportunity to defend against securities class actions.
Thus, as evidenced by the significant number of dismissals against auditors that have
resulted in the two years since the Tellabs decision was rendered, it is the competing
inferences component of the Tellabs scienter analysis, coupled with the fact that courts
continue to apply difficult standards for pleading auditor fraud, that appears to have
tilted the scales more toward an auditor defendant in the securities context.
--By Patricia A. Gorham, Amelia Toy Rudolph, and Juanita Passyn, Sutherland Asbill &
Brennan LLP.
Patti Gorham and Amy Rudolph are both partners with Sutherland in the firm's Atlanta
office. Nita Passyn is an associate with the firm in the Atlanta office.
The opinions expressed are those of the authors and do not necessarily reflect the
views of Portfolio Media, publisher of Law360.
[1] 127 S. Ct. 2499, 2504-05 (2007).
[2] Id. at 2509.
[3] See, e.g., Ezra Charitable Trust v. Tyco Int‟l Ltd., 466 F.3d 1 (1st Cir. 2006); Garfield
v. NDCHealth Corp., 466 F.3d 1255 (11th Cir. 2006); Fidel v. Farley, 392 F.3d 220 (6th
Cir. 2004); PR Diamonds Inc. v. Chandler, 364 F.3d 671, 693 94 (6th Cir. 2004); DSAM
Global Value Fund v. Altris Software Inc., 288 F.3d 385, 390-91 (9th Cir. 2002); Ziemba
v. Cascade Int‟l Inc., 256 F.3d 1194 (11th Cir. 2001); Melder v. Morris, 27 F.3d 1097
(5th Cir. 1994); DiLeo v. Ernst & Young, 901 F.2d 624 (7th Cir. 1990).
[4] Reiger v. PriceWaterhouse Coopers LLP, 117 F. Supp. 2d 1003, 1007 (S.D. Cal.
2000), aff‟d sub nom. DSAM Global Value Fund v. Altris Software Inc., 288 F.3d 385
(9th Cir. 2002). But see In re Countrywide Fin. Corp. Sec. Litig., 588 F. Supp. 2d 1132,
1197 n.79 (C.D. Cal. 2008) (dismissing claim against auditor but rejecting claim that
auditors have no financial incentive to defer to management).
[5] Reiger, 117 F. Supp. 2d at 1007.
[6] Public Employees‟ Retirement Ass‟n v. Deloitte & Touche LLP, 551 F.3d 305 (4th
Cir. 2009); Ley v. Visteon Corp., 543 F. 3d 801 (6th Cir. 2008); Edward J. Goodman Life
Income Trust v. Jabil Circuit Inc., No. 8:06-cv-01716, 2009 WL 179669 (M.D. Fla. Jan.
26, 2009); In re Countrywide, 588 F. Supp. 2d at 1198; Maiden v. Merge Tech., No 06________________________________________________________________________________________________________________
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C-349, 2008 WL 4643538 (E.D. Wis. Oct. 20, 2008); In re Dell, Inc., Sec. Litig, 591 F.
Supp. 2d 877 (W.D. Tex. 2008); In re Doral Fin. Corp. Sec. Litig., 563 F. Supp. 2d 461
(S.D.N.Y. 2008); Batwin v. Occam Networks Inc., No. CV 07-2750, 2008 WL 2676364
(C.D. Cal. July 1, 2008); Grand Lodge v. Peters, 550 F. Supp. 2d 1363 (M.D. Fla. 2008);
Edward J. Goodman Life Income Trust v. Jabil Circuit Inc., 560 F. Supp. 2d 1221 (M.D.
Fla. 2008); In re Witness Sys. Inc. Sec. Litig., No. 1:06-CV-1894-CC, slip op. at 15 n.5
(N.D. Ga. Mar. 31, 2008) [Dkt. No. 109]; Gold v. Morrice, No. CV 07-00931, 2008 WL
467619 (C.D. Cal. Jan. 31, 2008); In re Scottish Re Grp. Sec. Litig., 524 F. Supp. 2d
370 (S.D.N.Y. 2007); In re Faro Tech. Sec. Litig., 534 F. Supp. 2d 1248 (M.D. Fla.
2007); In re Nat‟l Century Fin. Enter. Inc. Fin. Inv. Litig., No. 2:03-md-1565, 2007 WL
2331929 (S.D. Ohio Aug. 13, 2007); Lewis v. Straka, No. 05C1008, 2007 WL 2332421
(E.D. Wis. Aug. 13, 2007); In re Parmalat Sec. Litig., 501 F. Supp. 2d 560 (S.D.N.Y.
Aug. 8, 2007).
[7] See In re New Century, 588 F. Supp. 2d 1206 (C.D. Cal. Dec. 3, 2008) (denying
motion to dismiss against auditor); In re IMAX Sec. Litig., 587 F. Supp. 2d 471 (S.D.N.Y.
2008) (same); Katz v. Image Innovations Holdings Inc., 542 F. Supp. 2d 269 (S.D.N.Y.
2008) (same).
[8] See PR Diamonds, 364 F.3d at 693; Fidel, 392 F.3d 227; DSAM Global, 288 F.3d at
390; Rothman v. Gregor, 220 F.3d 81, 98 (2d Cir. 2000).
[9] Fidel, 392 F.3d at 226 (quoting PR Diamonds, 364 F.3d at 693); see Rothman, 220
F.3d at 98.
[10] DSAM Global, 288 F.3d at 390.
[11] See Ley, 543 F.3d at 814 (“The same PSLRA pleading standards ... apply to the
allegations against [auditor]. However, the meaning of recklessness in securities fraud
cases is especially stringent when the claim is brought against an outside auditor.”);
Doral Fin. Corp. 2008 WL 2636864, at *2 (“[T]he recklessness required to hold a
„nonfiduciary accountant‟ liable for fraud „must, in fact, approximate an actual intent to
aid in the fraud being perpetrated by the audited company.‟”) (quoting Rothman, 220
F.3d at 98); Grand Lodge, 550 F. Supp. 2d at 1372 (“Plaintiff must offer specific factual
allegations that are sufficient to support the „strong inference that the audit was so
deficient that it amounted to no audit at all.‟”) (quoting In re Faro Techs. Sec. Litig., No.
6:06-cv-8-Orl-22DAB, 2007 WL 430731, at *20 (M.D. Fla. Feb. 3, 2007)); Scottish RE
Grp., 524 F. Supp. 2d at 385 (“The standard for pleading auditor scienter is
demanding.‟”) (quoting In re Refco Inc., Sec. Litig., 503 F. Supp. 2d 611, 657 (S.D. N.Y.
2007)); Nat‟l Century, 2007 WL 2331929, at *6 (“The meaning of recklessness in
securities fraud cases is especially stringent when the claim is brought against an
outside auditor.”) (quoting PR Diamonds, 364 F.3d at 693); Lewis, 2007 WL 2332421, at
*1 (no audit at all standard).
[12] See, e.g, Jeffrey B. Maletta et al., Supreme Court Clarifies “Strong Inference”
Pleading Under the PSLRA, SEC Enforcement Alert, June 2007 (“While the court
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rejected the anomalously pro-plaintiff standard adopted by the Seventh Circuit, the
Supreme Court‟s holding and other language in the opinion suggest a somewhat more
plaintiff-friendly view of securities class actions than had previously prevailed in many
circuits.”); see also Tellabs, 127 S.Ct. at 2516 (Alito, J., concurring in judgment)
(lamenting the court‟s failure to exclude facts not stated with particularity from the
“strong inference” test).
[13] See, e.g., Ley, 543 F.3d at 816 (rejecting allegations that auditor earned and
wished for greater fees insufficient to create an inference of scienter); Goodman Life
Income Trust, 2009 WL 179669, at *29 (rejecting as insufficient allegations that auditor
received significant fees and was client‟s auditor for 24 years); Dell Sec. Litig., 591 F.
Supp. 2d 877 (rejecting allegations of access to company‟s records, violations of GAAS
and GAAP, and conclusory allegations that auditors ignored red flags as creating
inference of scienter); Doral, 2008 WL 2636864, at *3 (allegations that auditor had
limitless access to information, obtained $6 million in fees during class period, was the
company‟s auditor since 1977, and performed many non-auditor services for the
company during the class period were all insufficient to infer scienter); Batwin, 2008 WL
2676364, at *18 (noting that red flags alleged by plaintiffs, including fact that company
was small and under-funded, never earned profits, and operated in highly competitive
industry, were too generic to support a strong inference of scienter).
[14] See, e.g., Sarah Gold and Richard Spinogatti, Post-Tellabs: Inference of Scienter in
Eye of Beholder, 10/11/2007 N.Y.L.J. 3 (col. 1).
[15] E.g., AICPA Professional Standards, AU § 110.03 (June 2008) (“The entity‟s
transactions and the related assets, liabilities, and equity are within the direct
knowledge and control of management. The auditor‟s knowledge of these matters and
internal control is limited to that acquired through the audit.”).
[16] E.g., AICPA Professional Standards, AU § 230.11 (June 2008) (auditor‟s judgment
involved in areas to be tested; nature, timing and extent of tests to be performed;
interpreting results of audit testing and evaluating audit evidence; evaluating
reasonableness of accounting estimates).
[17] Public Employees‟ Retirement Ass‟n, 2009 WL 19134, at *1 (evidence supported
inference that auditor was deceived by client: “Ahold would not have needed to go out
of its way to produce false evidence of control had [auditor] been complicit in the fraud,
or had they been so reckless in their duties that their audit amounted to no audit at all.”);
Doral, 563 F. Supp. 2d at 465 (evidence of secret side agreements and management‟s
falsification of documents supported inference that agreements were hidden from public
as well).
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