Securities Regulation - Tina M. Carew and Andrew J. Surdykowski

• Jurisdiction: United States,Federal
• Publication year: 2003
• Citation: Vol. 54 No. 4

Securities Regulationby Tina M. Carew^* and

Andrew J. Surdykowski^**

This Article surveys significant cases decided by the Eleventh Circuit during 2002 in the area of securities regulation. In particular, this Article analyzes cases brought against a company's outside auditors and outside legal counsel.

In the wake of recent corporate accounting scandals,¹ and as a product of the weak economy, plaintiffs have begun focusing their litigious attention towards outside auditors and outside legal counsel.² The outside auditors who are named as a defendant typically have issued audit opinions declaring that a company's financial statements fairly present the financial position of that company, and then the company is later required to restate its financial statements for the period of the audit.³ The company's outside legal counsel who are named as a defendant typically have issued a legal opinion for certain transactions and may be privy to material, nondisclosed information that the plaintiffs believe should have been disclosed. Section 10(b)⁴ and Rule 10b-5⁵ of the Securities Exchange Act of 1934 (the "Exchange Act") make illegal any material misstatement or omission in connection with the purchase or sale of any security. In general, when alleging fraud under Rule 10b-5 of the Exchange Act, plaintiffs must meet the Act's pleading requirements,⁶ as well as the specific pleading requirements of Federal Rule of Civil Procedure 9(b)⁷ and the Private Securities

Litigation Reform Act of 1995 (the "PSLRA").⁸ One element that a plaintiff must demonstrate in its Rule 10b-5 complaint is scienter. Scienter is defined as the "intent to deceive, manipulate, or defraud."⁹ To sufficiently plead scienter under the PSLRA, a complaint must state with particularity facts that give rise to a "strong inference" that the defendant acted with scienter.¹⁰ The Eleventh Circuit Court ofAppeals has established that scienter may be sufficiently pleaded by "alleging with particularity that a defendant acted with a severely reckless state of mind."¹¹

I. OUTSIDE AUDITORS

It is well established in the Eleventh Circuit that alleging a violation of generally accepted accounting principles ("GAAP") or generally accepted accounting standards ("GAAS") is not sufficient, by itself, to establish a strong inference ofscienter on the part ofan outside auditor, even if the auditor is grossly negligent in carrying out its responsibili-ties.¹² Rather, the Eleventh Circuit requires additional evidence of severe recklessness, such as facts placing a reasonable auditor on notice of wrongdoing, which the auditor chooses to ignore.¹³ The courts refer to these facts as "red flags." In 2002 two courts in the Eleventh Circuit expounded upon the scienter pleading requirements to evidence severe recklessness by the outside auditors, with one court finding that the plaintiffs met the requisite pleading requirements,¹⁴ and the other finding the plaintiffs did not.¹⁵

In In re Hamilton Bankcorp, Inc. Securities Litigation,¹⁶ plaintiffs claimed that Hamilton Bankcorp, Inc. ("Hamilton"), certain ofits control persons, and Deloitte & Touche, LLP ("Deloitte") engaged in a three-year scheme to artificially inflate and maintain the market price of Hamilton's stock.¹⁷ As a result, Hamilton was required to restate a number of its financial statements, which significantly reduced its net income.¹⁸ To satisfy the scienter pleading requirements with respect to Deloitte, plaintiffs claimed that Deloitte knew about and ignored the following red flags: the Office of the Comptroller of the Currency ("OCC") was conducting an intensive and wide-ranging investigation of Hamilton; Hamilton's simultaneous sale and purchase of overpriced loans or securities to avoid a write-down on its books; numerous violations of banking procedure and GAAP; and a press release issued by Hamilton in which it claimed that it was only taking additional reserves for exposure in Ecuador to appease its banking regulations, even though GAAP did not require the taking of the reserve.¹⁹ The District Court for the Southern District of Florida determined that the plaintiffs in Hamilton had satisfied the pleading requirements of the PSLRA and had alleged more than the existence of GAAP and GAAS violations.²⁰

In In re Sunterra Corp. Securities Litigation,²¹ Sunterra took a $44.3 million charge a year after Arthur Anderson, LLP issued an unqualified audit opinion.²² Plaintiffs alleged scienter on the part of Arthur

Anderson based on the magnitude of the GAAP violations, Arthur Anderson's awareness that it was required to comply with GAAS while conducting the audit, and the following red flags: Sunterra's lack of internal controls and Sunterra's motive to engage in fraud.²³ The District Court for the Middle District of Florida determined that plaintiffs in Sunterra did not meet the scienter pleading requirements and dismissed their complaint against Arthur Anderson.²⁴

In both Hamilton and Sunterra, the issue turned on whether plaintiffs pleaded facts in addition to violations of GAAP or GAAS that, when combined with those violations, established a strong inference of an intent to defraud or severe recklessness on the part of the independent auditors. In reaching their decisions, the courts focused on allegations of the following three facts: the magnitude of the error, the lack of internal controls, and the motive to commit fraud.

A. Magnitude of Error

The courts in both cases discussed the magnitude ofthe error resulting from the GAAP or GAAS violations as evidence of the outside auditor's severe recklessness. The court in Sunterra, while acknowledging the size of the overstatement in that case, determined that because only a portion of the overstatement could be attributed to Arthur Anderson,²⁵ the magnitude allegation "[fell] short of tilting the scales in favor of a finding of a strong inference of severe recklessness on the part of Arthur Anderson."²⁶ The court in Hamilton, finding that plaintiffs met the heightened pleading requirements, relied in part on the magnitude ofthe misstatement, "which significantly dwarf[ed] that recognized in [Cheney v. CyberGuard²⁷ ]," to find a strong inference of severe recklessness.²⁸ In 2000 the District Court for the Southern District ofFlorida concluded in CyberGuard that the size of the restatement in that case, "without evidence that the auditor was aware of the falsity of the original statement[]," was not sufficient to create an inference of scienter.²⁹ In 2001, however, the District Court for the Southern District of Florida in Holmes v. Baker³⁰ appeared to move away from the CyberGuard holding in finding "a limited inference of scienter based upon the magnitude allegations."³¹ The Hamilton and Sunterra cases, coupled with the decision in Baker, imply that courts in the Eleventh Circuit may begin to find a sufficient pleading of scienter based solely on the magnitude of the GAAP or GAAS violations. In 1998 the District Court for the Northern District of Georgia in Carley Capital Group v. Deloitte & Touche, LLP³² explicitly stated that allegations of GAAP violations "when combined with a drastic overstatement of financial results can give rise to a strong inference of scienter."³³ In the event the Eleventh Circuit courts do not follow this recent trend, magnitude allegations will remain an important factor in determining whether auditors acted with severe recklessness, although measures on the part of an auditor to prevent the fraud may counter a finding of severe recklessness.³⁴

B. Lack ofInternal Controls

In both cases, plaintiffs alleged that improper internal accounting practices, referred to as a lack of internal controls, were red flags ignored by the outside auditors. In Sunterra, plaintiffs alleged that Arthur Anderson should have been suspicious of Sunterra's improper internal accounting practices.³⁵ While plaintiffs contended that Arthur Anderson was frequently at Sunterra headquarters, had continual access to Sunterra's records as part ofits service as Sunterra's tax consultants, and attended Sunterra's audit committee meetings, plaintiffs did not allege that Arthur Anderson knew about the improper accounting practices.³⁶ As part of its review of other cases in which plaintiffs alleged a lack of internal controls as a red flag,³⁷ the court in Sunterra relied upon the decision by the District Court for the Southern District of Florida in In re Sunbeam Securities Litigation.³⁸ The facts in Sunbeam indicated that the auditors: (i) had served in such capacity for a long period of time, (ii) knew that the Sunbeam internal audit team was short staffed, (iii) were aware of an article appearing in Barron's magazine accusing Sunbeam of manipulating its financial statements, and (iv) had been tipped by one of Sunbeam's employees that Sunbeam had overstated its restructuring reserves.³⁹ The court in Sunterra noted that there were no similar allegations of tipping or knowledge alleged against Arthur Anderson in its case.⁴⁰ The court also analyzed the facts from Carley Capital,⁴¹ in which the court determined that scienter had been sufficiently pleaded.⁴² In Carley Capital, the court placed great weight on the fact that the outside auditors were significantly involved in the management of the company.⁴³ The court in Sunterra noted that Carley Capital was factually distinguishable because plaintiffs in Sunterra did not allege that Arthur Anderson was extensively involved in the management of Sunterra.⁴⁴ Because plaintiffs did not allege that Arthur Anderson had been tipped as to the accounting improprieties or was extensively involved in the management of Sunterra, the court determined that plaintiffs had not sufficiently pleaded that Arthur Anderson was severely reckless in issuing a clean audit opinion.⁴⁵

Unlike the court in Sunterra, the court in Hamilton held that plaintiffs adequately pleaded that the lack of internal controls at Hamilton was a red flag that...