Auditor Security Fraud: Negligence Not Enough Part II

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For the second time in a few weeks, the Second Circuit dismissed a securities fraud claim targeting an independent auditor. In Special Situations Fund III QP, L.P.,, the Court was tasked with reviewing the trial court’s dismissal of plaintiff’s second amended complaint.  The underlying allegations were that the company disclosed that its former CEO and other executives had committed fraud for years by misstating its financials and embezzling funds. Plaintiff alleged that the company’s independent auditor committed securities fraud by issuing a “clean audit opinion” of the company. Ultimately, the Appellate Court upheld the dismissal on the grounds that the plaintiff failed to properly plead the requisite element of scienter.

The Second Circuit noted that in order to state a fraud claim under the Private Securities Litigation Reform Act (“PSLRA”), Plaintiff was required to “state with particularity facts giving rise to a strong inference” that the auditor acted with the requisite scienter. In attempting to do so, Plaintiff highlighted a number of alleged “red flags” which they alleged were “recklessly disregarded,” including the allegation that if the auditor had conducted an appropriate audit investigation it would have discovered money had been embezzled.

However, the Court noted that it was nowhere alleged that the auditor was required to check the documentation which would have revealed the alleged nefarious acts, and that conditional allegations (like those alleging Defendant would have learned the truth if it had just performed due diligence), are insufficient to establish scienter in this context.

Finally, the Court held that the District Court had correctly dismissed the fraud claims on the basis that the auditor’s “clean audit opinions” constituted “false or misleading statements.” The Court stated that even though it argued that the auditor had “omitted to disclose…[it] had conducted a recklessly deficient audit investigation” on which its “clean” opinions were based, and that “it knew of numerous facts that outright contradicted those opinions,” that Plaintiff had failed to adequately allege or articulate the basis of such allegations in its Complaint.

This constitutes another victory for independent auditors. The defense community hopes that this line of decisions represents the continuing trend of courts taking a hard stance on unsupported claims of fraud on the part of an independent auditor.