Monday, July 30, 2012

Finding Scienter Sufficiently Alleged, Second Circuit Panel Reinstates Securities Fraud Claim against Audit Firm

The independent auditor of a company’s financial statements may have acted with scienter with regard to revenue recognition involving some transactions, ruled a Second Circuit panel. While at the time the audit firm considered these transactions to be red flags warranting heightened scrutiny, noted the panel, the firm ultimately approved the company’s recognition of revenue in connection with each of these transactions. There was evidence that in the course of its audit Grant Thornton learned of and advised against the use of indisputably deceptive accounting schemes, said the appeals court, but eventually acquiesced in the schemes by issuing an unqualified audit opinion. Thus, the panel held that the securities fraud claims could go forward since the investors set out enough facts constituting evidence of conscious misbehavior or recklessness to survive a motion fir summary judgment. Gould v.Winstar Communications, CA-2 July 19, 2012.

GT requested that the company’s counterparties provide additional documentary evidence of the relevant sales underlying each questionable transaction. By doing so, consistent with SEC Staff Accounting Bulletin 101, in which the SEC states four conditions that must be satisfied before revenue can be recognized, GT sought to obtain independent support for the company’s recognition of revenue for each transaction, in other words, support from documents that were not generated by the company itself. As of February 10, 2000, GT still had not received responsive documents from four of these customers. Nonetheless, it issued an audit opinion letter opining that the company’s 1999 financial statements accurately reflected its financial condition and complied with GAAP.

The appeals court found evidence supporting the contention that GT consciously ignored the company’s fraud when it approved the company’s recognition of revenue for the suspicious 1999 transactions. This evidence goes beyond a mere failure to uncover the accounting fraud and, in general, relates to the company’s recognition of revenue for the sale of equipment or services without sufficient indicia of delivery, its recognition of all revenue associated with the incomplete sale of telecommunications systems, and its recognition of revenue for sales of indefeasible rights of use, equipment, and services to financially unstable companies to whom the company paid back large sums under separate contractual obligations. There was also evidence that GT failed to confirm the company’s representations regarding these transactions or to retain and review documents evidencing each transaction.