Second Circuit Clarifies Primary Liability Standards for Auditors

The following was first published on 2/28 over at Securities Litigation Watch, my new blog.

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Earlier this week, the Second Circuit held that an auditor has a duty to correct its prior certified opinions, and may be held liable under § 10(b) and Rule 10b-5 if it fails to do so. The opinion appears to be the first in the Second Circuit to squarely hold that an accountant has such a duty or may be primarily liable under the federal securities laws.

A copy of the opinion in Overton v. Todman & Co., CPAs, P.C., is available from the Second Circuit, here, or from FindLaw (reg. req'd), here.

The opinion reverses a lower court decision dismissing a securities fraud claim against the auditor, and its successor in interest, Trien, Rosenberg, Rosenberg, Weinberg, Ciullo & Fazzari, LLP.

From 1999 through 2002, Todman audited the financial statements of Direct Brokerage, Inc. (“DBI”), a broker-dealer registered with the Securities and Exchange Commission and a member firm of the New York Stock Exchange. Each year, Todman issued its “unqualified” opinion that DBI’s financial statements accurately portrayed the company’s fiscal health.

Despite its certifications of accuracy, Todman was alleged to have made significant errors that concealed DBI’s largest liability, payroll taxes. The plaintiffs alleged that Todman ignored multiple red flags that cast serious doubt on the accuracy of DBI’s financial statements, and alleged a number of facts in support of their assertion that Todman recklessly audited DBI’s affairs and recklessly evaluated whether DBI could “survive as an ongoing concern.” Plaintiffs alleged that, in 2003, DBI’s payroll tax liability led to the broker-dealer’s collapse.

The Court surveyed its prior law on primary accountant liability and concluded:

that for many years we have recognized the existence of an accountant’s duty to correct its certified opinions, but never squarely held that such a duty exists for the purposes of primary liability under § 10(b) of the 1934 Act and Rule 10b-5. Presented with an opportunity to do so, we now so hold.

The Court held that the District Court erred in dismissing the fraud claim against Todman & Co., and that an auditor may have primary liability under § 10(b) and Rule 10b-5 for a failure to correct a prior audit opinion, when 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. knows or should know that potential investors are relying on the opinion and financial statements; yet
4. fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and
5. all the other requirements for liability are satisfied.
   

The Court went on to note two limits to the holding.

First, the Court held:

that an accountant has a duty [only] to correct its prior certified statements, as opposed to a broader duty to update those statements. The duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by intervening events, even if the statement was true when made.

Second, the Court noted:

that an accountant need correct only those particular statements set forth in its opinion and/or the certified financial statements. Unless an accountant exchanges its role for the role of an insider an accountant is under no duty to divulge information collateral to the statements of accuracy and financial fact set forth in its opinion and the certified financial statements, respectively.

The Court was clear to note that the Todman holding did not conflict with Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), which held that there was no aiding and abetting liability under § 10(b), as the auditor in this litigation had acted as a speaker in a primary capacity.