The Duty to Correct: The Second Circuit Speaks

By Mark A. Segal

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JULY 2008 - In Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (U.S. S.Ct. 1994), the U.S. Supreme Court issued an opinion that has been construed as a rejection of the notion of secondary liability based upon “aiding and abetting” the commission of a primary Section 10(b) and Rule 10(b)(5) violation under the Securities Exchange Act of 1934. The decision in Central Bank left open the possibility that secondary parties could be held primarily liable under Section 10(b) and Rule 10(b)(5). In this regard, the Supreme Court noted:

The absence of Section 10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the Securities Acts. Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator of Section 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 have been met.

As a consequence of Central Bank, securities litigation against accountants has frequently focused on whether plaintiffs could assert a viable claim for a primary Section 10(b) and Rule (b)(5) violation. Two recent decisions by the Second Circuit Court of Appeals—Lattanzio v. Deloitte & Touche, LLP [476 F.3d 147 (2d Cir. 2007)] and Overton v. Todman & Co. [478 F.3d 479 (2d Cir. 2007)]—touch on a specific aspect of recent securities litigation, namely the extent to which accountants face a “duty to correct.”

Lattanzio

Lattanzio v. Deloitte & Touche, LLP, in its pertinent part, concerned whether there exists a duty to correct quarterly statements (10-Q) that had been reviewed but not audited. The case involved the appeal of a District Court’s dismissal of a securities fraud action against Deloitte & Touche. The Second Circuit affirmed the District Court decision. According to the court, a duty to correct does not equate to remaining silent concerning an actionable misstatement in a 10-Q. Accountants cannot merely be held “responsible for the company’s statements ... because the accountant may know those statements are likely untrue.” Citing United States v. Natelli [527 F.2d 311 (2d Cir. 1976)], the Second Circuit noted that an accountant has a “duty to correct” only where the accountant has audited and issued a certificate concerning financial statements.

The plaintiffs had argued that a review should be considered a confirmation of the company’s financial statements, due to its being mandated for quarterly statements. The court rejected equating a review with issuance of a certified opinion on the financial statements. According to the court, if Congress had intended to impose duties on a review similar to those associated with the rendering of an audit opinion, it would have more clearly established such a rule for review engagements:

Absent an audit opinion, the existence of a duty to correct cannot by itself translate Deloitte’s silence regarding the 10-Qs into an actionable misstatement. If an accountant does not issue a public opinion about a company … the accountant cannot be held responsible for the company’s public statements ... merely because the accountants may know those statements are untrue ... The accountant’s duty extends only “to correct those financial statements which the accountant had audited itself and had issued its certificate.” See in this regard Shapiro v. Cantor, 123 F.2d 717 (2d Cir. 1997), In re Cascade International Securities Litigation, 894 F. Supp. 437 (S.D. Fl., 1995), and Chiarella v. United States, 445 U.S. 222 (U.S. S.Ct.1980).

The court also rejected the plaintiff’s claim that a review should be construed as an opinion on the financial statements, due to the market construing a review as a form of assurance as to their accuracy. Likewise, the court rejected the assertion that federal regulations place a duty on accountants to correct “unaudited statements” if they are false and that a failure to meet such duty constitutes a breach of Section 10(b).

Pursuant to the court’s analysis, companies have a choice with respect to interim financial statements (i.e., a 10-Q) in that they can either—

  • Affirmatively state that the filing was reviewed by an accountant in conformity with the regulation, and include the accountant’s report, or
  • Not mention the mandated review, in which case no accountant report will be filed.

The court also rejected the plaintiff’s assertion that failure to treat a review as giving rise to duties comparable to those of an audit would make a review a largely meaningless exercise. According to the court, the fact that a review may be considered optional does not make it meaningless, as the conduct of a review helps to increase the likelihood that quarterly statements will be properly or timely prepared.

Nevertheless, a review does not constitute a statement attributable to the accountant for 10(b)(5) purposes. Note that, in Chiarella v. United States, the Supreme Court found that in order for primary liability to be found based upon silence, there had to be a duty to speak.

Overton

Overton v. Todman and Co. concerned the appeal of an order by the U.S. District Court of the Southern District of New York to dismiss the plaintiffs’ claim of damages due to a primary violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)(5) by an accounting firm that had conducted a related audit. The Second Circuit Court of Appeals vacated the dismissal and remanded the case to the District Court. The Second Circuit framed the issue of concern as being:

[W]hether an auditor may incur primary liability under Section 10(b) and Rule 10(b)(5) when the auditor provides a certified opinion that is false or misleading when issued, subsequently learns or was reckless in not learning that the earlier opinion was false or misleading, knows or should know that potential investors are relying on the opinion, yet fails to take reasonable steps to correct or withdraw its opinion and/or underlying financial statements.

Facts. The auditor, Todman and Co., had issued unqualified opinions for 2002 and earlier years. These opinions had been filed with the financial statements of the client, Direct Brokerage, Inc. (DBI). The plaintiffs alleged that the auditor had made significant errors that led to a failure to report large payroll tax liabilities. Arguably, these liabilities should have been examined; they went from being the largest liability of the company in 1998 to zero in 1999. The plaintiffs asserted that there were various “red flags” which should have placed the auditor on alert for such liabilities. Included among the red flags were:

  • A large payroll tax liability in 1998 that the auditor had noted merited additional investigation.
  • No post-1998 payroll tax liabilities, despite the fact that individuals were working for the company.
  • The auditor knew that the client had individuals working for it, and that the client had payroll taxes that were due.
  • The company’s payroll tax obligations dropped to zero in 1999, despite there being a substantial increase in the compensation paid.
  • The auditor did not investigate why these developments occurred.

DBI encountered difficulty with the New York State Division of Taxation, resulting in the company conducting its own internal investigation. The internal investigation found that the ex-CFO had not recorded payroll tax liabilities on the company’s books. In addition, the company hired a forensic accounting firm which determined that the outside audit was “deficient in certain respects.”

According to the court, accountants have a duty to correct misstatements that are discovered in financial statements the accountant has prepared and certified, and upon which they know the public is relying. The Second Circuit had previously addressed a case in which the issue of a duty to correct arose with respect to a situation wherein investors brought an action alleging primary liability by an accountant with regard to financial projections which had appeared in a partnership-offering memoranda but did not indicate that one of the principals had been convicted of a felony or that the principal’s 12-year-old son was the sole officer, director, and shareholder of the managing entity. The court found that the accountant could not be held liable, as there was no duty to disclose for merely making projections. To quote Shapiro [123 F.3d 717 (2d. Cir. 1997)], amenability to primary liability in the case required that there had been a certified opinion:

The concept of a duty to disclose appears to stem from the extent of reliance on the accountant’s work made by the public and the expectations of the public. Clearly, in a situation in which the accountant “gives an opinion or certifies statements” about a company—statements which the accountant later discovers may not have been accurate ... then the accountant has a duty to disclose the fraud to the public. ...

Conversely, if an accountant does not issue a public opinion about a company, although it may have conducted internal audits or reviews for portions of the company, the accountant cannot subsequently be held responsible for the company’s public statements issued later merely because the accountant may know those statements are likely true. [See also In re Cascade International Securities Litigation, 894 F. Supp. 437 (S.D. Fla., 1995).]

Overton and the Certified Opinion: An Overview

In Overton, a certified opinion had been issued by the auditor. Thus, the duty to disclose was conceivable. Issuance of a certified opinion provides a measure of assurance as to the credibility of the financial statements, so that others may rely on such financial statements as having been audited by a certified professional (i.e., a special relationship with the public or trust). In this regard, a certified opinion is distinct from other types of work issued by an accountant. Issuance of such opinion establishes a special relationship between the accountant and other parties, that is, the investing public and outside creditors. The certified opinion indicates that the accountant is acting “independently to provide assurance as to whether the company statements have been audited and that such work, procedures, and analysis and the consequent representations and opinion are accurate and reliable.” Furthermore, the court noted that a duty to disclose facts may also arise where the accountant acts as an insider, rather than as an independent party.

Thus, according to the Second Circuit, an accountant could be found primarily liable under Section 10(b) or Rule 10(b)(5), due to the violation of a duty to correct where the accountant:

1) makes a statement in its certified opinion that is false or misleading when made; 2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; 3) know[s] or should know that potential investors are relying on the opinion and financial statements; 4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and 5) all other requirements for liability are satisfied.

The court’s decision in Overton appears to be consistent with Central Bank of Denver in that, for liability, the accountant must make a misleading omission by failing to correct its certified opinion, and the reliance by investors on the accountant’s omission constitutes a component of the duty to correct.

Implications

It should be kept in mind that in Overton, it is the duty to correct a certified opinion that was at issue, and not a purported duty to update the financial statements themselves. The issue of whether there is a duty to update the opinion generally relates to situations where the accountant has made a statement which later proves to be inaccurate due to intervening events.

Section 10(b) and Rule 10(b)(5) continue to be raised by plaintiffs as grounds for accountant liability. The Lattanzio and Overton decisions provide insight into the analysis used in such cases. In evaluating these cases, it is important to note that these were decisions of the Second Circuit Court of Appeals, and other circuits might not follow the same reasoning. Likewise, other grounds and arguments continue to be potential sources of accountant liability, such as common law or other securities law provisions.

A balance must be struck that includes reasonable protection of third parties, while not subjecting secondary actors to unreasonable risk. The integrity of the capital markets remains dependent upon the availability and effective provision of audit services. As the determination of appropriate standards of care continues to evolve, it should be noted that the fortunes of audit services and the capital markets are intertwined. At present, the Big Four dominate the audit of publicly held companies. While these firms should be held to reasonable and consistent standards with regard to such services, an allowance of too ambiguous or inconsistent grounds for liability risks defeats the exact purpose that the audit was intended to serve. The potential consequences of ambiguous or inconsistent grounds for liability include the following:

  • The lack of available or affordable insurance for auditors;
  • Increased tension between the auditor and the corporation to be audited;
  • Increased allotment of time for engagements and procedures, with an attendant increase in cost; and
  • Increased likelihood of further concentration of, if not the eventual absence of, competition between providers of audit services.

As noted in 2006 by the United States Chamber of Commerce, the potential risk of being held liable for civil fraud with regard to audit engagements is so severe that, one day, the audit profession may be deemed uninsurable.


Mark A. Segal, LLM, CPA, is a professor of accounting at the Mitchell College of Business, University of South Alabama, Mobile, Ala.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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