Roving Scienter

It can be difficult for plaintiffs to adequately allege that an outside auditor acted with scienter when issuing its audit opinion. Accordingly, the Ninth Circuit’s decision last week to reverse the dismissal of the securities fraud claims against an outside auditor is worth examining.

In New Mexico State Investment Council v. Ernst & Young LLP, 2011 WL 1419642 (9th Cir. April 14, 2011), the court addressed E&Y’s alleged role in Broadcom’s options backdating scheme. At issue was a 2005 unqualified audit opinion that covered three years of Broadcom’s financial statements (2003–05). The court found that each of the following three allegations, whether taken individually or viewed collectively, were sufficient to find a strong inference that E&Y had acted with scienter:

(1) E&Y knew the material consequences of a May 2000 backdated option grant that would have resulted in a $700 million charge to Broadcom’s financial results but, despite violations of GAAS, signed off on the grant without obtaining documentation;

(2) E&Y knew that several significant option grants in 2001 were approved on dates when Broadcom’s compensation committee was not legally constituted due to the death of one of the two committee members; and

(3) E&Y presided over corrective reforms in 2003 to prevent and detect any future instances of improper stock option awards without questioning the integrity of Broadcom’s accounting for options granted prior to the corrective reforms.
The court also examined several other factual allegations related to scienter, including allegations of insufficient documentation, weak internal controls, and red flags related to Broadcom’s stock option grants.

Of particular concern to auditor defendants, however, may be the court’s rejection of E&Y’s argument that the plaintiffs had failed to show that any of the E&Y personnel who participated in the 2005 audit were aware of the earlier alleged backdating that impacted Broadcom’s 2005 consolidated financial statements. E&Y described this as an attempt to apply “roving scienter” over a long time period. The court disagreed, concluding that “EY, despite serving continuously as Broadcom’s auditor from 1998 until 2008, during which it attested to the accuracy of Broadcom’s financial statements for the multiple years noted in the 2005 Opinion, cannot now disclaim those prior opinions simply because the same individuals were not involved.”

Holding: Dismissal of claims against outside auditor reversed.

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