Will Auditors Ever Answer To Investors For Aiding And Abetting?

The House – Senate Wall Street Reform and Consumer Protection Act Conference reconvened on Tuesday, June 15 and Compliance Week says a version of the Specter Bill – to repeal the Supreme Court’s Stoneridge decision – will not be included in whatever comes out of the process.

Bruce Carton in Compliance Week: As this process gets underway, auditors, lawyers, bankers and other advisers to public companies are quietly breathing a sigh of relief that one of the items no longer on the table is an amendment proposed by Sen. Arlen Specter that would have overturned the U.S. Supreme Court’s 2008 ruling in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., thereby permitting “aiding and abetting” liability for a company’s auditors and others. The final version of the financial reform bill that passed the Senate did not include the Specter amendment.

However, a coalition of state regulators, public pension funds, professors, consumers and investors and the attorneys who advise them, are still working to put something back in the bill as an amendment to restore the right of investors to defend themselves and hold white collar criminals accountable.

Their email to me states:

The amendment brought by Senators Arlen Specter (D-PA), Jack Reed (D-RI), Dick Durbin (D-IL) and many other senior Democrats would have enacted one simple change in current anti-investor law – law that was “legislated” by a conservative Supreme Court rather than the U.S. Congress. The reform would have restored the right of pension funds and other investors to hold accountable in courts those who knowingly aid and abet securities fraud.

This legal right of investors, which for fifty years helped white collar crime victims recover their losses while also deterring future fraud enablers, was stripped from shareholders and bondholders by the radical Stoneridge Supreme Court decision of 2008, which expanded upon an earlier misguided Court decision in order to throw out thousands of remaining meritorious fraud claims brought by retirement funds and individual investors against investment banks and others who helped design the Enron fraud – the largest financial crime in U.S. history.

Earlier this Spring, a Federal appeals court cited the “Supremes” and threw out the legitimate claims of ripped-off shareholders and bondholders in the billion dollar Refco, Inc. derivatives fraud.  In Refco, a now criminally convicted corporate lawyer had worked with Refco’s senior execs to execute fake transactions as a paper trail leading to falsified financial statements that were issued to investors and the public.

Both Congressman Barney Frank and Senator Ted Kaufman responded to questions about the Specter amendment during my visit to Washington DC for Compliance Week’s Annual Conference.  House Financial Services Committee Chairman Frank said at the conference that he was in favor of bringing the amendment back in the bill.  Senator Kaufman, although a co-sponsor of the original amendment, is in favor but does not think it’s likely.

I’ve written quite a bit about the impact of third party liability on the auditors in fraud claims and the Stoneridge decision.

In February of 2008 , I wrote about Treasury’s attempt to address the nagging issues of viability and sustainability of the accounting profession.

They punted.

I have consistently disagreed with the Big 4’s claim that auditor liability caps are necessary to avoid losing one of the remaning firms to catastrophic litigation. I have lamented the fact that the auditors don’t get sued often enough for my tastes and, when they do, they often settle. I’ve also said that they don’t deserve our pity, as they are less than transparent regarding their true financial capacity to address ongoing litigation…

“The Treasury Department established the Advisory Committee on the Auditing Profession to examine the sustainability of a strong and vibrant auditing profession.”

John P. Coffey, the Co-Managing Partner of Bernstein Litowitz Berger & Grossmann LLP… agrees with what I have been saying on this blog all last year.

It is with this perspective that I address one of the questions the Committee is considering, namely, whether there ought to be a cap on auditor liability. I respectfully submit that the case for such a cap has not been made…

…the fact that, in today’s environment, auditors are rarely named as defendants in these actions. In a three-year period immediately before the PSLRA was enacted – April 1992 through April 1995 – auditors were named as defendants in 81 of 446 private securities class actions filed, for an average of 27 suits per year, or 18% of all private securities class actions. As the reforms of the PSLRA and the concomitant jurisprudence took hold, that number dropped precipitously. Auditors were named as defendants in only five suits in 2005, and only two cases in each of 2006 and 2007.

The number for 2007 is especially telling because approximately one out of every eleven companies with U.S.-listed securities – almost 1200 companies in all – filed financial restatements in 2007 to correct material accounting errors. Further, an analysis of securities actions filed in 2006 and 2007 demonstrates a significant decline in the number of cases alleging GAAP violations, appearing to suggest “a movement away from the focus in recent years on the validity of financial results and accounting treatment.”

Well, that’s changed post-financial crisis.  In addition to the big frauds like Satyam, Glitnir, the Madoff feeder funds and garden variety accounting malpractice claims, the auditors are named in high profile subprime cases where fraud is alleged such as New Century and Lehman.

It’s still not a deluge, since the PSLRA makes it damn difficult to draw the auditors in without a smoking gun or, actually, a rogue mechanical pencil. Even with a top notch bankruptcy examiner’s report – I’m talking Refco here – it’s not easy.

July 11, 2007, Bloomberg

Refco Inc.‘s tax accountant, Ernst & Young, and a company law firm may have helped the defunct futures trader defraud investors, according to an examiner’s report unsealed today.

Ernst & Young, the second-biggest U.S. accounting firm, and Mayer Brown Rowe & Maw, a Chicago-based law firm, might face claims by Refco for aiding and abetting the fraud, examiner Joshua Hochberg said in a report filed in U.S. Bankruptcy Court in New York. Grant Thornton, the sixth biggest U.S. accounting firm, might face claims of professional negligence for work it did before Refco’s bankruptcy, Hochberg said.

Contrast that seemingly slam-dunk assessment with this report on August 22, 2009:

Two accounting firms and a law firm won dismissal of a lawsuit on behalf of former Refco Inc currency trading customers who lost more than $500 million when the defunct futures and commodities broker went bankrupt.

U.S. District Judge Gerard Lynch on Tuesday said Marc Kirschner, a trustee representing the customers, failed to show that Ernst & Young LLP [ERNY.UL], Grant Thornton LLP and the law firm Mayer Brown LLP knew of or substantially assisted in the fraudulent diversion of assets that led to Refco’s demise.

The Manhattan federal judge, however, gave permission for Kirschner to file a new complaint. Citing the trustee’s access to a “substantial trove” of Refco documents, Lynch said: “It is far from clear that repleading would be futile.”

In his 35-page opinion, Lynch said Grant Thornton’s work gave it “a complete picture of how Refco and the Refco fraud, functioned.”

He also said Mayer Brown “actively participated in carrying out Refco’s fraudulent misstatement of its financial position,” while Ernst performed to work for Refco “despite apprehending the scope of the fraud.”

Judges, even while granting motions to dismiss, have more than once bemoaned the fact that the law does not allow them to act differently. In case after case, the judges are forced to let culpable third-party actors in these frauds off the hook.

It’s been especially frustrating in the Madoff feeder fund cases. In the case of CRT Investments, Ltd, et al v. J. Ezra Merkin, Gabriel Capital, BDO Seidman, LLP, and BDO Tortugas, “the court dismissed aiding and abetting fraud claims because the plaintiffs could not allege the required intent. Mere recklessness was not sufficient in the absence of ‘specific red flags that the accountant disregarded that would place a reasonable accountant on notice that the audited firm was engaged in wrongdoing which is detrimental to the investors.’  The court expressed its frustration that the law prohibited further exploration of the alleged wrongdoing.”

Finally, the court notes that these types of allegations of scienter against auditors of investment funds in these situations appear to be recurring, yet they cannot go beyond the motion to dismiss stage and into discovery under the present state of the law.  The inability to explore the alleged wrongdoing any further and potentially hold these parties accountable is frustrating to the court.

What’s confusing to me is that the Private Securities Litigation and Reform Act (PSLRA) restored the SEC’s ability to use “aiding and abetting” as a tool for enforcement of the securities laws but private plaintiff’s still can not.  It’s as if Congress at the time, pre-Enron, believed plaintiffs and their lawyers too irresponsible to bring reasonable causes of actions.  As if litigation against guilty parties is ever a bad idea… This perversion of the “free-market” philosophy, wherein bad companies are deemed good for the economy so we allow their bad actions with impunity and encourage others to help them, is particularly pernicious.

Tom Gorman at Porter Wright tells us: “The dividing line between primary and secondary liability in securities fraud actions has been a key subject of debate since 1994 when the Supreme Court handed down its decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). There, the high court held that Exchange Act Section 10(b), the antifraud weapon of choice for the SEC as well as private litigants, did not reach aiding and abetting. In the wake of that decision, the circuits have split on the question of primary and secondary liability. Some have adopted the “bright line” test, initially fashioned by the Tenth Circuit and later developed and amplified by the Second Circuit. The Ninth Circuit, in contrast, used the “substantial participation test.” Both tests are discussed here.

Congress partially addressed the issue by restoring the SEC’s aiding and abetting authority in the PSLRA. Nevertheless, the issue continues to be of importance in its enforcement actions. Congress has declined to extend aiding and abetting authority to private securities fraud plaintiffs.”

And Gorman again here: “In 1995, when the PSLRA restored aiding and abetting liability in SEC enforcement actions in the wake of Central Bank, the SEC urged Congress to extend liability on this basis to private actions. At that time, Congress was more focused on limiting liability in private damage actions. Now however, Congress is considering a host of provisions which would greatly expand liability under the federal securities laws. While those proposals focus on enhancing the power of the SEC, there is little doubt that the Commission will support Senator Specter’s bill which would greatly expand the reach of private damage actions based on Exchange Act Section 10(b). This would be consistent with the SEC’s frequently stated view that private damage actions are a necessary adjunct to its enforcement program.”

The SEC can use the terms “aiding and abetting” all it wants and does so quite often.  They succeed with serious charges when the courts sometimes fail to hold the same perpetrators accountable.  When it comes to the auditors, the SEC can hold them accountable, and does occasionally, but often very late and the courts dismiss.

By issuing these false and misleading audit opinions, E&Y was a cause of and aided and abetted Bally’s violations of Sections 17(a)(2) and (3) of the Securities Act and Sections 13(a) and (b)(2)(A) of the Exchange Act and Exchange Act Rules 12b-20, 13a-1, 13a-11, and 13a-13. E&Y also violated Section 10A of the Exchange Act by not bringing to the attention of Bally’s Audit Committee Bally’s false and misleading disclosures of the $55 million special charge.

Tom Gorman lays out the opposing views of the Supreme Court on the original Stoneridge decision in a way that highlights the pro-business versus pro-investor bias inherent in the decision.  In light of everything wicked that has come our way since Enron, is this really the plan we want to stick to?

Justice Kennedy concludes with three points. First, he cites policy: “Were the implied cause of action to be extended to the practices described here, however, there would be a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.” Second, adoption of petitioner’s theory is contrary to Central Bank and the PSLRA. Finally, the day is long past when the Court will expand an implied cause of action such as the one involved here in view of separation of powers concerns….”

…according to Justice Stevens, the sham transaction alleged in the complaint had the same effect on Charter’s profits as a false entry and is more than sufficient. And, permitting an action to proceed based on this kind of sham transaction will not inhibit business because it is an isolated departure from ordinary transactions… Justice Stevens concludes his dissent with what might be viewed as an ode to the implied cause of action. While it is clear that Justice Stevens views himself neither as a liberal or an activist judge, the closing paragraphs of his opinion chide the majority for their swipes at implied causes of action. These causes of action are based on “A basic principle animating our jurisprudence … [that was] enshrined in state constitution provisions guaranteeing, in substance, that ‘every wrong shall have a remedy.’ Fashioning appropriate remedies for the violation of rules of law designed to protect a class of citizens was the routine business of judges …,”

Thus, while the Court’s decision is pro-business, it is also pro-enforcement, but through SEC actions, not class actions. Finally, Justice Stevens is no doubt correct in his lament: the days when the federal courts could be viewed as the protectors of all those whose rights have been violated have passed.”

If you believe the federal courts should be viewed as the ultimate protectors of all those whose rights have been violated, I urge you to call or write the members of the Senate Banking Committee. Shine some strong sunlight on these cases.

Urge your Senators and Congressmen to support a repeal of Stoneridge and a restoration of the private right of action for aiding and abetting of fraud, in particular by third parties such as auditors.

Cover Image found at the Ambigrams by Nagfa blog.

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  1. […] isn’t liability because he did not explicitly make the false statement. Auditors can sometimes be fraud “aiders and abettors” but typically skip out on that claim when Section 10(b) is […]

  2. […] diluted.Civil penalties against audit firms as a whole will be severely rationed.  The private right of action against audit firms will be constrained by the PSLRA, the Stoneridge decision, obdurate judges, […]

  3. […] acts to the corporation, therefore precluding the corporation from suing a third party for aiding and abetting the fraud, means a New York audit is basically worthless if corporate officers are guilty. The […]

  4. […] law so it’s clear to judges, to restore the right to allege in private claims that third-parties “aided and abetted” frauds, were left out of the Dodd-Frank […]

  5. […] courts and the laws support this immunity, for the most part.  The regulators have been active but fairly impotent to change auditors’ […]

  6. […] the Martin Act is the law used by Cuomo to bypass all the other constraints mere mortals have in suing the Big 4 audit firms. It’s quite a powerful tool, as Eliot Spitzer showed us. […]

  7. […] diluted. Civil penalties against audit firms as a whole will be severely rationed.  The private right of action against audit firms will be constrained by the PSLRA, the Stoneridge decision, obdurate judges, and […]

  8. […] for accounting rules that benefit their clients and laws that limit their accountability (read, “PSLRA” and the “Stoneridge” decision, (c) they use accounting rules (read, “special purpose entities,” […]

  9. […] we know, the case could not be brought under federal securities laws since the PSLRA bars private actions for aiding and abetting a fraud and, Grant emphasized to me, “Congress has not yet seen fit to amend this law to give private […]

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