In the SDNY, Hindsight Is No Substitute for Red Flags When Alleging Scienter

Letter to Shareholders

On April 8, 2013, Judge Shira A. Scheindlin of the Southern District of New York granted auditor Deloitte Touche Tohmatsu CPA’s (“DTTC”) motion to dismiss a shareholder class action, finding that plaintiffs failed to sufficiently allege scienter or any misstatements by DTTC pursuant Section 10(b) and Rule 10b-5 of the Securities Exchange Act. Plaintiffs alleged that DTTC issued unqualified audit opinions on behalf of its client Longtop from 2009 to 2011. During that period, Longtop reported very strong financial results, which were later revealed to be fraudulently inflated.

In May 2011, DTTC released a public letter of resignation as Longtop’s auditor, disclosing that its second round of bank confirmations were cut short by Longtop’s deliberate interference, that Longtop’s CEO admitted the company’s books were fraudulent, and that DTTC had resigned due to that admission and Longtop’s deliberate interference with its audit. As a result, the NYSE stopped trading on Longtop’s securities and delisted the company.

In dismissing shareholder claims against DTTC, the court applied the stringent test for plaintiffs to meet when alleging scienter against an auditor. Because “an outside auditor will typically not have an apparent motive to commit fraud, and its duty to monitor an audited company for fraud is less demanding than the company’s duty not to commit fraud,” an auditor’s mere failure to identify problems with a company’s internal controls and accounting practices will not constitute recklessness. 

Instead, the threshold to allege recklessness by an auditor is not sufficiently met unless a plaintiff can show that the “accounting practices were so deficient that the audit amounted to no audit at all.” Showing recklessness by an auditor under this standard requires a plaintiff to allege specific red flags that would put a reasonable auditor on notice that their client was engaged in wrongdoing. Mere allegations of an auditor’s access to information is insufficient to show recklessness.

In analyzing Plaintiffs’ scienter allegations, the court rejected Plaintiffs’ alleged red flags, finding that DTTC’s audit did not violate GAAS and PCAOB requirements, despite the fact that in hindsight, the additional procedures proposed by Plaintiffs would have revealed the fraud sooner. The court also held that showing a duty to correct under the GAAS does not establish an auditor’s duty to correct under the Exchange Act. Rather, scienter based on the Exchange Act’s duty to correct is established by showing that DTTC actually knew of its client’s fraud or was reckless in not learning that its previous audit was false or misleading prior to resigning as outside auditor. The Court held that Plaintiffs failed to show that DTTC was reckless in failing to further investigate based on Plaintiffs’ alleged red flags, finding that the alleged sources of the red flags were unreliable, and thus DTTC’s duty to investigate was correspondingly slight.

Lastly, the Court ruled Plaintiffs’ allegations that DTTC’s identification of deficiencies in Longtop’s internal controls and risk factors did not constitute recklessness by DTTC for failing to identify any fraud committed by the company, noting that allowing such allegations to pass a motion to dismiss would expose auditors to legal liability whenever it identified risk factors at a company ultimately discovered to be engaged in fraud.