Legal Insights, a quarterly publication produced by the Issue Management Group of Chartis Insurance, published an article in its Spring/Summer 2011 edition written by partner Don Willenburg entitled "Ninth Circuit Court of Appeals Increases Vulnerability of Auditors in Suits Alleging Fraudulent Backdating of Stock Options."
In the article, Mr. Willenburg analyzed the recent decision by the Ninth Circuit Court of Appeals that reversed a district court's dismissal of the class action complaint against Ernst & Young LLP in New Mexico State Investment Council v. Ernst & Young LLP. Rejecting the district court's view that scienter (state of mind) allegations against accountants or auditors carry "a little bit of a heavier burden," the Ninth Circuit Court stated that a securities fraud complaint adequately pleads scienter by "raising a strong inference that the defendant possessed actual knowledge or acted with deliberate recklessness." The Court made it clear that outside auditors are subject to a federal securities lawsuit by a corporation's shareholders and are not benefitted by a heightened scienter requirement.
Plaintiffs in New Mexico State Investment Council v. Ernst Young LLP claimed that Ernst & Young, as Broadcom’s auditor, was complicit in a decade-long stock option backdating scheme and also complicit in fraudulent accounting practices that caused Broadcom’s stock to be artificially inflated. The decision is expected to result in an increased threat of suits against outside auditors by third parties, such as the shareholders of an auditor’s client.
As Mr. Willenburg further explained, the Ninth Circuit Court’s decision also illustrated some of the differences between federal and state law with respect to auditor liability. At this point, the case is citable precedent in the state court forum, but the result in the case may change if a petition for rehearing at the Ninth Circuit or certiorari from the Supreme Court is granted.
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