Auditor Securities Fraud: Negligence isn’t Enough

Unlike most malpractice scenarios, alleged negligence is not enough to sustain a claim in the context of securities fraud against an independent auditor. Rather, in most jurisdictions the plaintiff must establish that the audit was of such little value that it was a “pretend” audit which provided no benefit. Alleging that the auditor could have done more is insufficient absent properly pled allegations that the auditor maintained an evil intent or acted with reckless conduct. This standard is fairly well-developed. Yet, the exposure is often considerable and “victims” of alleged fraud committed by public companies continue to target the independent auditors engaged to audit those companies. A recent decision out of the SDNY highlights another victory for the defense community in securities fraud cases targeting an auditor.

In re DNTW Chtd. Accountants Secs. Litig., was a securities class action case brought under Sections §10(b) and §20(a) of the Securities and Exchange Act. Plaintiffs purchased shares of a company which was allegedly engaged in fraud. Plaintiffs alleged that the Company’s independent auditor knowingly turned a blind eye and deliberately disregarded the “obvious fraud” being committed by the Company. In purported support, Plaintiffs pointed to the “clean” audit reports and suggested the reports were materially false and misleading.  Plaintiffs allege that they relied on the audit reports to their detriment.

Moreover, and importantly, Plaintiffs allege that following the Company’s termination of Defendant Auditor, their successor auditor uncovered the fraud with ease. Plaintiffs alleged that there was strong circumstantial evidence of conscious misbehavior or recklessness by the auditors, amounting to fraud, in that they allegedly: (1) ignored “red flags” that should have put it on notice of the Company’s fraud; (2) “failed to adjust audit procedures in light of the red flags”; and (3) “actually eased [its] audit procedures” in violation of standards.

The Court granted the Defendant Auditors’ Motion to Dismiss and held that Plaintiffs failed to show that the auditors had disregarded alleged “red flags” which were themselves “indicative of actual fraud,” and that simply asserting that someone should have exercised greater “professional skepticism” was not the same as alleging ignorance of obvious indications of actual fraud, or engaging in conduct that approximates an actual intent to aid in fraud.

Noting that mere violations of accounting standards is not sufficient to establish scienter, and that an audit must have been so shoddy that it was, essentially, a pretend audit, the Court found that Plaintiffs’ allegations failed to meet the demanding standard. The Court noted that allegations of accounting irregularities must be accompanied by facts suggesting corresponding fraudulent intent, facts which were not present in the Complaint.

Finally, the Court found that the inference that the auditors engaged in deliberate illegal activity or acted with recklessness approximating an intent to aid the Company’s fraud was not as compelling as the competing inferences, noting that the auditor was, more plausibly, itself fooled, or that it simply performed shoddy, negligent audits, not fraudulent ones. These decisions, and those like it, are critical to an auditor faced with allegations of securities fraud.