Holding Third Parties Liable For Complicity in Fraud: Auditors and Securities Fraud

Auditors can help their corporate clients by playing an important role in preventing and detecting securities fraud. Many auditors, however, fail to prevent and detect such fraud and have even been found to be complicit in certain circumstances in their clients’ fraudulent activities. As a consequence, a growing number of securities fraud lawsuits name the company’s auditor as a defendant, alleging that the auditor also violated federal securities laws.
Many recent high-profile securities fraud cases filed by investors, including Enron, WorldCom, Cendant, and Tyco, named auditors as defendants. The increasing number of auditors as named defendants in cases involving corporate fraud is largely due to the fact that the vast majority of those cases allege that the company perpetuated accounting irregularities and that the company filed misleading financial statements with the SEC. Based on those allegations, investors often also assert that the company’s auditors were complicit in their clients’ misconduct and liable to the company’s investors because auditors generally oversee the company’s accounting practices and prepare and certify the company’s financial statements.

The Auditor’s Role

Public companies hire outside auditing firms (historically including Ernst & Young, Deloitte & Touche, Arthur Andersen, and KPMG) to perform audits that examine the companies’ financial situation and compliance with applicable laws and regulations. These audits must be performed in strict accordance with a set of standards established in the auditing industry, referred to as Generally Accepted Auditing Standards (“GAAS”). By adhering to GAAS, auditors assure investors that a company’s financial statements comply with the SEC mandated Generally Accepted Accounting Principles (“GAAP”) and fairly present the company’s current financial position in all material respects. In reaching such assurances, auditors must review and test the financial statements contained in their clients’ annual and quarterly SEC filings. These filings typically contain a signed, certified statement from the company’s auditor testifying to the accuracy of their contents. If, however, there is evidence that the auditor knew that the company’s SEC filings contained false and misleading statements, an investor may hold the auditor liable through a private action under the federal securities laws.

Establishing a Case Against an Auditor
Courts have stated that an auditor certifying a public company’s financial statements performs a “public watchdog” function because it is attesting to the accuracy of the information presented to investors and the market. Accordingly, courts have found that holding auditors liable under the federal securities laws is justified because public investors reviewing a company’s financial statements rely heavily on the integrity of the auditor’s certification.

But to hold an auditor liable under the federal securities laws, an investor must, first and foremost, show that the financial statements in question contain fraudulent statements or omissions. Second, an investor must demonstrate that the auditor certified the financial statements despite knowing that the financial statements were false and misleading or that the auditor acted recklessly in not establishing the truth of the statements contained in the financial statements. This may be accomplished by demonstrating that the auditor specifically counseled its client to adopt risky and misleading accounting practices.

By either knowingly certifying false financial statements or recklessly failing to oversee their clients’ compliance with established accounting practices, auditors violate federal securities laws and inject uncertainty into the financial markets. Therefore, investors that suffered losses because they relied on an auditor’s assurances can recover directly from the auditor through a private cause of action.

As discussed above, several high-profile cases have drawn attention to the potential liability of an auditor and the role auditors may play in securities class actions — most notably in the case against Enron. In that infamous case, investors sued Enron and its auditor, Arthur Andersen, because, after continuously reassuring investors that all of Enron’s financial statement and accounting practices had been scrutinized and certified by Arthur Andersen, the company’s financial statements were found to be fraudulent. Arthur Andersen was alleged to be liable for having verified those false statements. This case is also instructive because Arthur Andersen was found to have destroyed a considerable amount of electronic and paper documents related to Enron’s financials and accounting practices. As a result, investors, investigators and attorneys were denied thousands of emails and other paper files that could have been used as evidence to further help demonstrate the extent of Enron and Arthur Andersen’s fraudulent activities. Enron investors eventually obtained a $75 million settlement from Arthur Anderson.

In the case against WorldCom, investors alleged that the company’s auditor, once again Arthur Andersen, was liable for failing to thoroughly examine the company’s financial statement and accounting practices and for allowing enormous accounting fraud to unfold at the company. Instead of fulfilling its obligations to investors, the case alleged that Arthur Andersen took a “see-no-evil” approach in order to please WorldCom executives and to ensure payment for its auditing services. In midst of the trial, Arthur Anderson decided to settle the case against it by WorldCom investors for $65 million.

Similarly, in the case against Tyco, investors claimed that the accounting firm Pricewaterhouse-Coopers failed to uncover the fraud that led the company to overstate its income by $5.8 billion. The auditor ultimately opted, after four years of litigation, to settle the Tyco investor case for $225 million.

These cases serve to demonstrate the severe repercussions that exist for auditors in securities fraud cases should they fail to diligently perform their duties as independent auditors. Auditors are imparted with important obligations to investors and should they enable the fraud perpetrated by company insiders, they too should be, and continue to be, held liable.


newsletter nov2008.jpg Source : Scott+Scott November 2008 Newsletter