A federal judge ruled that investors in a private securities fraud action against a failed financial services company adequately alleged the outside auditor’s scienter, its misstatements, and loss causation. The court ruled that the complaint adequately alleged the auditor’s recklessness, if not actual knowledge, based on its awareness of red flags and its duty to investigate. Thus, Judge Sweet refused to dismiss the securities charges against the audit firm. In Re Bear Stearns Companies,Inc. Securities, Derivatives, and ERISA Litigation (SD NY) 08 MDL 1963,Jan. 19, 2011.
The financial instruments (fair value)balance sheet line item was the largest asset on the company’s balance sheet, comprising one third of the company’s total assets. It was alleged that the audit firm failed to perform targeted procedures to assess the internal controls over financial reporting of the fair value of financial instruments, as required by PCAOB Auditing Standards Nos, 2 and 5, resulting in the disclosure of the fair value of financial instruments that were not valued in accordance with GAAP.
It is more specifically alleged that, in violation of AS Nos. 2 and 5, the auditor recklessly disregarded proper testing of company-level controls including risk management processes, internal controls of the company’s risk management processes, and varying pricing approaches by trading desks which enabled the company’s disclosure of its low VaR number.
Investors further alleged that the auditor failed to test internal controls for potential abuses in the company’s mortgage origination business, thereby allowing the company to continue to use lax underwriting and loan origination standards.
Investors said that the company’s concentration of mortgage securities in excess of its internal policy limits constituted another red flag which left it exposed to declines in the riskiest part of the housing market, and represented reckless disregard for the guidance provided by the AICPA’s Statement of Position 94-6, on the disclosure of significant risks and uncertainties.
The court noted that the company repeatedly downplayed the risks and falsely asserted that they constantly checked and updated their VaR models to improve their accuracy. The company failed to disclose facts that would have alerted investors to grave problems with its risk models, and did nothing to appraise the market of the true state of affairs. The court said that the audit firm’s alleged failures as auditor of the financial statements allowed for these misstatements to go unchecked and mislead investors. Investors sufficiently alleged that the risks which the audit firm was complicit in concealing materialized and caused them harm. Contrary to the audit firm’s suggestion, noted the court, neither a restatement of financial statements nor an admission of wrongdoing is necessary to establish loss causation.
The investors also alleged that the audit opinion failed to comply with GAAP and GAAS, recklessly disregarded red flags which would have alerted the auditor to the falsity of the financial statement. One alleged red flag was that the company had persisted in using mortgage valuation models that the SEC had repeatedly criticized as inaccurate or outmoded. Another alleged red flag was that the collateral the company received as a result of the bailout of one of its hedge funds was far less than the value of the loan the company had offered the fund.
In the context of an accounting firm’s audits, explained the court, the scienter requirement for a securities fraud claim is satisfied by alleging that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts.
Moreover, allegations of red flags, when coupled with allegations of GAAP and GAAS violations, are sufficient to support a strong inference of scienter. A complaint might reach this no audit at all threshold, said the court, by alleging that the auditor disregarded specific red flags that would place a reasonable auditor on notice that the audited company was engaged in wrongdoing to the detriment of its investors.