Question

Explain the term scienter, its relation to auditing of financial statements and its role in the legal liability exposure of auditors.

Answer 1

Scienter is a legal term for intent or knowledge of wrongdoing. An offending party then has knowledge of the "wrongness" of an act or event prior to committing it.

Introduction

Despite the fact that securities fraud lawsuits involving auditors are said to be relatively few in number as a percentage of total new filings and new filings are below the historical average, auditors often come to be added as defendants, particularly in high-profile cases.1 In the past few years, for example, auditors have been named as parties in the five proceedings with the largest total dollar value settlements to date -- Enron, WorldCom, Cendant, Tyco and AOL Time Warner2 -- and in several other well-known actions including Global Crossing, Parmalat and Delphi. With the majority of all cases historically alleging accounting irregularities and over 90% of last year's filings reportedly containing alleged misrepresentations in financial documents, suits against auditors are never far off.3

This article reviews first the role of the auditor and reminds counsel of the benefits of understanding and educating the court regarding the role of the auditor, namely that the auditor does not prepare a company's financial statements; rather, the auditor opines on the fair presentation of management's financial representations based on the auditor's testing those representations. This article then surveys three areas of law germane in suits against auditors: (1) scienter requirements with respect to auditors; (2) the scope of primary liability and scheme liability with respect to auditors; and (3) one firm theories asserted against international audit firms.

II. The Role of the Auditor

Counsel litigating securities cases involving auditors would be wise always to be mindful of the role of the auditor. The auditor's potential liability in securities actions generally is for alleged misrepresentation stemming from his audit opinion, included in the financial section of a reporting company's annual report (Form 10-K). It does not stem from the reporting company's financial statements themselves, for which management alone takes responsibility and as to which the auditor declares his independence.

Putting aside theories of liability for secondary actors discussed later in this article, the auditor is not liable for misstatements appearing in the company's unaudited interim (Form 10-Q) financial reports or in related company announcements, although plaintiffs often assert otherwise. The simple reason is that the auditor rarely, if ever makes public representations regarding those interim financial statements. Unless the auditor undertakes to review and issue a published report on the interim financial statements, the auditor is only liable for his published audit reports on the company's annual financial statements, even though federal regulations (17 C.F.R. § 210.10-01(d)) require the company's auditor to "review" quarterly financial statements. The Second Circuit recently reaffirmed this rule in Lattanzio v. Deloitte & Touche LLP (Warnaco Sec. Litig.), 476 F.3d 147, 154-156 (2d Cir. 2007) (no auditor liability for alleged misstatements in unaudited quarterly financial statements) (citing Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) and In re Kendall Square Research Corp. Sec. Litig., 868 F. Supp. 26 (D. Mass. 1994)).

While the auditor's role may seem basic to some, courts and counsel often articulate the auditor's role inartfully or get it just plain wrong. Plaintiffs sometimes assert that it is the auditor that prepares or is responsible for the company's financial statements. See, e.g., In re Raytheon Securities Litigation, 218 F.R.D. 354, 356 (D. Mass. 2003) ("The Second Amended and Consolidated Class Action Complaint alleges that . . . [the auditor] issued materially false and misleading financial statements in violation of the Generally Accepted Accounting Principles."). Oftentimes, courts pick up on and repeat without analysis these formulations.See, e.g., In re Cendant Corp. Securities Litigation, 343 F.3d 658, 660 (3rd Cir. 2003) (referencing Ernst & Young LLP as the "auditor who prepared the Cendant financial statements at issue in the underlying litigation"). As yet another variant, courts often refer to the auditor as having "certified" the financial statements, which may be less inaccurate depending on the circumstances, but nevertheless is still not quite right. See, e.g., Overton v. Rodman & Co., CPAs, P.C., 478 F.3d 479 (2nd Cir. 2007) (reciting that "[t]he auditor had issued certified financial statements."); Tricontinental Industries, Ltd. v. PricewaterhouseCoopers, LLP, 475 F.3d 824, 828 (7th Cir. 2007) (auditor "certified that Anicom's financial statements were accurate").

The "independent" auditor does not, indeed cannot, prepare a company's financial statements and at the same time paradoxically issue an independent opinion on those statements. As the standard audit opinion makes clear, management prepares and takes responsibility for its financial statements. The auditor engaged by management conducts audit procedures in accordance with generally accepted auditing standards (GAAS) in order to provide assurance regarding whether the company's financial statements, taken as a whole, fairly present in all material respects in accordance with generally accepted accounting principles (GAAP) the company's financial position as of a given date (generally a fiscal year end date) and the results of its operations and cash flows for the period then ending. The Supreme Court has summarized part of the process as follows:

In an effort to control the accuracy of the financial data available to investors in the securities markets, various provisions of the federal securities laws require publicly held corporations to file their financial statements with the Securities and Exchange Commission. Commission regulations stipulate that these financial reports must be audited by an independent certified public accountant in accordance with generally accepted auditing standards. By examining the corporation's books and records, the independent auditor determines whether the financial reports of the corporation have been prepared in accordance with generally accepted accounting principles. The auditor then issues an opinion as to whether the financial statements, taken as a whole, fairly present the financial position and operations of the corporation for the relevant period.

U.S. v. Arthur Young & Co., 465 U.S. 805, 810-11 (1984). See also Bily v. Arthur Young & Co., 834 P.2d 745, 750 (Cal. 1992) ("The end product of an audit is the audit report or opinion . . . [on] the specific client-prepared financial statements.").

The auditor's report is generally the best place to go to find a concise statement of the process followed by the auditor to reach his opinion, as well as the nature of the opinion. The auditor's report generally closely follows a prescribed form. The form of the standard audit opinion is as follows: