In a decision with potential implications for securities fraud claims against accounting firms, the U.S. Court of Appeals for the 2nd Circuit recently upheld a lower court’s dismissal of securities fraud claims by shareholders of Doral Financial Corporation (Doral) against Doral’s auditor, PricewaterhouseCoopers (PwC). The litigation arose after Doral, a financial services company that engages in mortgage and commercial banking, restated its financial statements for the years 2000 through 2004. The restatements showed that Doral had overstated its pre-tax income by $920 million and understated its debt by $3.3 billion.
The plaintiffs alleged that Doral engaged in at least two substantial frauds involving the securitization of mortgages. First, the plaintiffs claimed that Doral engaged in “side deals and oral agreements” that essentially turned the “sales” of the securities into secured borrowings, resulting in an overstatement of earnings and an understatement of debt.
Second, the plaintiffs claimed that Doral improperly valued the interest-only strips (IO Strips) that it retained as part of the securitizations by using “manufactured” assumptions to conceal losses in its IO Strip portfolio. With respect to PwC, the plaintiffs claimed that the firm’s audit reports and its report on Doral’s internal controls were materially false and allowed Doral to conceal and perpetuate its frauds. On this basis, the plaintiffs claimed that PwC, like Doral, violated Section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5.
Last year, Judge Jed Rakoff of the Southern District of New York dismissed the claims against PwC, holding that the plaintiffs failed to allege the requisite scienter under the Private Securities Litigation Reform Act (PSLRA). In a summary order issued Sept. 3, 2009, the 2nd Circuit agreed. Citing the U.S. Supreme Court’s 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., the 2nd Circuit noted that under the PSLRA, a plaintiff must “state with particularity facts giving rise to a strong inference” of scienter, or an intent to “deceive, manipulate or defraud.”
The inference of scienter must be such that a reasonable person would deem it “cogent and at least as compelling as any opposing inference one could draw” from the same alleged facts. The court stated that this burden could be met by alleging facts showing that the defendant had “both motive and opportunity to commit the fraud,” or constituting “strong circumstantial evidence of conscious misbehavior or recklessness.” However, in determining whether the alleged facts were sufficient to raise a “strong inference” of scienter, the court was required to “take into account plausible opposing inferences,” even if neither party had raised them.
The court acknowledged that the plaintiffs raised “numerous allegations of carelessness” by PwC, but concluded that the allegations failed to create a strong inference of recklessness. The plaintiffs alleged, for instance, that PwC recklessly failed to uncover the side agreements that altered the terms of the mortgage sales. However, the plaintiffs also alleged that the side agreements were a “tightly held secret,” known only to a few individuals within Doral’s management. The court therefore held that it was more plausible that PwC failed to discover the side deals because Doral’s management hid them from PwC.
The court reached a similar conclusion regarding the plaintiffs’ claim that PwC recklessly failed to discover Doral’s manipulation of the IO Strip valuations provided by two outside firms, Morgan Stanley and Popular Securities. As discussed in the District Court’s opinion, the plaintiffs alleged that a Doral director induced a Morgan Stanley employee to “stamp” the valuations with a Morgan Stanley authorization, even though the employee was not authorized to do so. The plaintiffs also alleged that Morgan Stanley and Popular Securities simply “regurgitated” valuations provided by Doral, rather than independently valuing the IO Strips.
The 2nd Circuit acknowledged that it may have been “more prudent” for PwC to investigate the assumptions underlying the valuations. However, it also noted that auditing standards in effect at the time allowed PwC to rely on outside valuations. Given the plaintiffs’ allegations that Doral manipulated “independent” valuations upon which PwC was allowed to rely, the court concluded that the inference that Doral deceived PwC was more compelling than the inference that PwC recklessly performed its audits. Thus, the court held that the alleged facts failed to support a strong inference of scienter.
Lastly, the court held that PwC’s failure to identify problems with Doral’s internal controls was insufficient to establish recklessness. It also noted that the plaintiffs had alleged that Doral overrode several of its internal controls, which further undermined any inference of recklessness by PwC.
The court closed by stating that the plaintiffs’ allegations of PwC’s recklessness might be “plausible” under the general pleading standards established by the Supreme Court in Bell Atlantic Corp. v. Twombly and Ashcroft v. Iqbal. However, the court continued that “the PSLRA requires . . . more than mere plausibility.” Because the “competing inference” that Doral deceived PwC was stronger than the inference that PwC was reckless, it was proper to dismiss the claims.
Indeed, it is not uncommon for securities fraud claims to allege that the individuals within a company who perpetuated an alleged fraud took steps to conceal their actions and ignored or circumvented the company’s system of internal controls. Following the court’s rationale, allegations of this nature would give rise to a strong “competing inference” that the auditor, like the plaintiffs themselves, was a victim of the fraud, and therefore should not be held liable for it.
It should be noted that the competing inference prevailed even though, as the District Court noted, the plaintiffs alleged that PwC personnel were “regularly present” at Doral and had “unlimited access” to information regarding its operations, and that PwC violated GAAP and GAAS in conducting its audits. The District Court held that these allegations were insufficient to establish scienter unless accompanied by some evidence of “corresponding fraudulent intent.” The same was true of the plaintiff’s allegations that PwC had a financial incentive to ignore the fraud because it collected more than $6 million in fees from Doral and provided non-audit services to Doral during the relevant period. The 2nd Circuit did not disturb these conclusions.
In effect, the decisions by the District Court and the 2nd Circuit require allegations of facts rising to the level of deliberate or willful ignorance of misconduct (if not conscious knowledge or active participation) in order to hold an auditor liable under Section 10(b) and Rule 10b-5. Indeed, the District Court framed the issue in these terms when it discussed – and dismissed – allegations based on information allegedly provided by a former Doral internal auditor that PwC personnel attended meetings of the Doral Audit Committee at which questions about the company’s internal controls were raised:
At most, [the former internal auditor’s] information may raise an inference the PwC was negligent in not following up on such discussions, but it certainly does not show the conscious turning away from the true facts required for recklessness.
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