With its keen interest in legal rules affecting independent auditors of financial statements, the Center for Audit Quality has filed an amicus brief in a private securities fraud case before the US Supreme Court concerning whether an investment adviser to a family of funds can be liable under Rule 10b-5 for statements that are made by and attributed to the funds if the adviser participated in the drafting and dissemination of the statements and if a court infers that interested investors would attribute the statements to the adviser. This case is especially important to auditors, said CAQ, because auditors are frequently named as defendants in private securities cases based on allegations that the auditor is liable for the client’s statements even though the statements were not made by or publicly attributed to the auditor. Janus Capital Group, Inc. v. First Derivatives Traders, US Supreme Court, Docket No. 09-525.
The Supreme Court agreed to review a Fourth Circuit panel ruling that fund shareholders adequately alleged that the investment adviser made misleading statements, and that the statements at issue were properly attributable to the adviser. Oral argument is set for December 7, 2010. Specifically, the shareholders alleged that the prospec¬tuses of several of the funds created the mis¬leading impression that the adviser would implement measures to curb market timing in the funds when in fact secret arrangements with several hedge funds permitted market timing transactions.
Every public company must file with the SEC an annual financial statement that has been audited by a certified public accountant, noted CAQ, and these audits typically result in an audit report containing specific, public statements by the audit firm. In the case of domestic companies, the auditor represents that the audit was conducted in accordance with PCAOB standards. If an “unqualified” opinion is warranted, the auditor represents that the audit provides a reasonable basis on which to opine that the financial statements present fairly, in all material respects, the financial position of the company, the results of its operations, and its cash flows, in conformity with GAAP.
But, said CAQ, investors and courts sometimes believe that audit reports are tantamount to assurances that the financial statements reflect the only permissible description of the company’s financial performance and are completely accurate. According to CAQ, that belief is wrong for two reasons. First, the application of GAAP requires the exercise of professional judgment and often permits a range of reasonable judgments about how to account for particular transactions. Second, even the most rigorous audit will not examine every accounting transaction in the company’s records, and may not detect every instance of mistake or fraud.
CAQ therefore considers it important to protect auditors from liability arising merely from a misleading representation or omission in a company’s financial statements, and believes that it is wrong to attribute such a representation or omission to the auditor. Rather, auditors should be responsible only for their own statements.
Since auditors also have no control over the public statements made by a company or its executives, emphasized CAQ, investors cannot reasonably assume that such statements have been vetted and approved by the company’s auditor. Vague standards that permit auditor liability based on that assumption, or on an auditor’s consultation on accounting matters that are implicated in a misleading statement or omission by the company, said CAQ, would subject auditors to large litigation costs and risks when they have done nothing wrong.
In CAQ’s view, the interests of auditors and investors alike will be best served by clear standards delineating the circumstances in which auditors may incur liability in private securities fraud actions. Investors will benefit from knowing when they may rely on an auditor’s actual or assumed opinion concerning statements made by companies. Auditors will benefit from clear rules that will protect them from liability for non-violative conduct.
The CAQ believes that the Fourth Circuit’s decision in this case, and the liability standard it enshrines, disserves investor and auditor interests. The liability standard adopted by the Fourth Circuit is inconsistent with the Supreme Court’s 1994 Central Bank ruling that there is no private action against secondary actors for aiding and abetting securities fraud.
According to CAQ, the Fourth Circuit ignored Central Bank’s core principle requiring liability standards that draw a clear distinction between a defendant’s own statements or omissions and the statements or omissions of others by holding that a defendant may be deemed to have made a statement merely by participating in the writing or dissemination of a statement made by someone else.
While the Fourth Circuit standard emphasizes that investment advisers to the fund that issued the statement controlled the drafting and dissemination of the fund’s statements, much like corporate insiders, CAQ noted that the standard draws no distinction between insiders who control the issuance of a statement, and outside professionals such as auditors who do not exercise such control but might be said to have participated in the creation of the statement. The suggestion that primary liability can arise if a defendant participates to a sufficient degree would make it exceedingly difficult for outside professionals to obtain dismissal of a securities complaint if the professional had even the most fleeting involvement in the allegedly misleading statement.
Central Bank and the requirement that investors must prove reasonable reliance on the defendant’s statement also requires that they must prove that a statement was expressly attributed to the auditor or outside professional. Without such attribution, reasoned CAQ, investors can at most assume that the auditor endorsed a statement made by its client company, and reliance based on such an assumption is inherently unreasonable. Again, CAQ pointed out, auditors typically do not control a corporation’s statements or speak on its behalf.
Further, CAQ argued that imposing liability on an outside audit firm for a statement made by the company but not expressly attributed to the auditor would encourage investors to rely on the incorrect assumption that an auditor must have endorsed every statement a company makes merely because the auditor opines on the company’s financial statements taken as a whole. Investor interests would be best served by emphasizing, rather than obscuring, the difference between statements that have been made by an auditor and those that have not, concluded CAQ.