In Auditor Suit, Second Circuit Says Quantity Does Not Always Mean Quality

The U.S. Court of Appeals for the Second Circuit has revived a federal securities class action against Grant Thornton LLP regarding its unqualified 1999 audit opinion indicating that Winstar Communications Inc.’s 1999 financial statements was in conformity with generally accepted accounting principles. The Second Circuit’s opinion is notable because it finds that, despite an apparently thorough audit (in terms of hours spent and documents reviewed) a fact finder could still find enough evidence of a conscious disregard of signs of fraud to support an inference of recklessness. In other words, even where an auditor does a significant amount of work on an audit, such work will not necessarily immunize the auditor from securities claims.

Winstar, a broadband communications company whose core business was to provide wireless internet connectivity to various businesses, filed for bankruptcy in April 2001, one month after an investment firm began publicly questioning its accounting practices.

Plaintiffs maintained that Grant Thornton issued an unqualified audit opinion that Winstar’s year-end 1999 financial statements set forth in the company’s SEC Form 10-K were in conformity with GAAP, despite its alleged knowledge of accounting improprieties by Winstar, one of Grant Thornton’s largest clients at the time. At issue were nine allegedly bogus transactions that Winstar entered into at the end of 1999, which enabled Winstar to realize almost $115 million in revenues. These transactions allegedly involved: purported sales of equipment that was never shipped by Winstar; sales of services never rendered; sales of equipment that Lucent Technologies, Winstar’s strategic partner, purchased as a favor to Winstar provided Lucent could “swap out” the equipment later on; and sales to undercapitalized companies that Winstar propped up with equity infusions and reciprocal transactions.

Plaintiffs contended that Grant Thornton was aware of various red flags in connection with these transactions, including the lack of any indication that any such goods or services were ordered and delivered.

The district court granted Grant Thornton’s motion for summary judgment, holding that that there was no genuine issue of material fact as to whether Grant Thornton had acted intentionally or recklessly in issuing its unqualified audit opinion for fiscal year 1999. In support of its holding, the court placed emphasis on the magnitude of the audit work. Grant Thornton had spent 1,928 hours of professional time, had assembled working papers spanning 3,000 pages, and had reviewed numerous documents, including copies of contracts, Winstar business plans, press releases, board minutes, and memos.

On appeal the Second Circuit reversed, holding that the number of hours spent on an audit cannot, standing alone, immunize an account firm from charges that it has violated the securities laws. According to the court, regardless of the number of hours spent or volume of documents reviewed in the course of the audit, Plaintiffs introduced evidence that Grant Thornton did not scrutinize serious signs of fraud by an important client. The court found that there was at least some evidence that Grant Thornton consciously ignored these red flags relating to various accounting issues, including: suspicious end-of-quarter transactions, round-trip transactions in which revenues were subsequently offset by Winstar’s payments to financially unstable customers under unrelated contractual obligations; the absence of documents confirming the goods or services ordered by Winstar customers, the fact of delivery, or the existence of an underlying agreement; and the repeated failure of Winstar to provide supporting documentation requested by Grant Thornton. Given this evidence, a jury could find that the audit was so deficient that the risk of fraud was either known to Grant Thornton or so obvious that it must have been aware of it.

Plaintiffs alleged that Grant Thornton violated Section 10(b) of the Securities Exchange Act of 1934 and made false and misleading statements in the audit opinion letter. On July 19, 2012, the Second Circuit vacated the Southern District of New York’s dismissal of the case on summary judgment, holding that a jury reasonably could determine that Grant Thornton’s audit of Winstar’s 1999 financial statements was “so deficient” as to be “highly unreasonable, representing an extreme departure” from the standards of ordinary care in violation of the anti-fraud provisions of the federal securities laws.