Auditor Can’t Escape ANR Action

KPMG Bermuda has lost it’s bid to be dismissed from the ANR securities class action.Senior Judge Ellen Bree Burns (D. Conn.) (pictured left) evaluated the audit firm’s alleged knowledge and intent, holding that “repeated restatements can… raise an inference of scienter.”

The other prong of her opinion addressed materiality, with Judge Burns finding that KPMG Bermuda’s audit opinions, which said that “ANR’s financial statements fairly represented its financial position and were created in accordance with GAAP,” “were relied upon by investors making their investment decisions,” and “thus, plaintiffs have adequately pled the existence of material misrepresentations made by KPMG Bermuda.”

You can read Schnall v. ANR, issued August 30, 2006 at 2006 U.S. Dist. LEXIS 61898

Nugget: “While allegations of GAAP and GAAS violations alone are generally not sufficient to create a strong inference, of reckless behavior, where plaintiffs have alleged facts showing that there were numerous red flags that KPMG must have been aware of, if it were conducting any kind of audit, reckless conduct can be, and has been, inferred.”

Molex Misdeeds

Judge Ruben Castillo (N.D. Ill.) describes it as “a complex securities case involving numerous allegations of corporate misdeeds amid suspicious factual circumstances, including the resignation of Molex‘s independent auditor, several undisclosed accounting errors, and multiple short-term changes in accounting methods.” And it seems those alleged suspicious misdeeds were more than enough for Defendants to lose their motions to dismiss.

Judge Castillo touched on lots of issues, but said that “although the magnitude of the accounting errors in the instant case were a relatively small percentage of Molex’s total income,” “Plaintiffs have detailed each of Defendants’ prior notice of the various errors and manipulative accounting methods, as well as their alleged conscious decision not to reveal the errors to the public or to their independent auditor.” So “although general allegations of GAAP violations are insufficient, ‘[t]he critical facts alleged by the plaintiffs in this case are the identification of the specific transactions alleged to have violated GAAP and the amount of detail provided in explaining those transactions.’”

You can read Takara Trust v. Molex, issued April 28, 2006, at 2006 U.S. Dist. LEXIS 29655.

Nugget: “While SAB No. 99 does not carry the force of law, SEC staff accounting bulletins constitute a body of experience and informed judgment, and SAB No. 99 is thoroughly reasoned and consistent with existing law.”

NextCard Execs Can’t Blame Auditor

Looks like the NextCard securities class action is going to be around for a while. If you hadn’t heard, the case was thrown out at the motion to dismiss stage back in February 2005, but Plaintiff were allowed to try again, and that’s exactly what they did. This time, they fared much better, with Judge Jeremy Fogel (N.D. Cal.) concluding that he was “not persuaded by Defendants’ argument that the certification of the company’s financials by its outside auditor, Ernst & Young, LLP (“E&Y”), negates or weakens the inference of scienter. Plaintiffs originally named E&Y as a defendant in this action based upon allegations that E&Y was a knowing participant in a scheme to defraud the market and in colluded in accounting improprieties. E&Y has settled with Plaintiffs. Under these circumstances, the fact that E&Y certified the financials does not raise an inference that the financials were appropriate or that Defendants were entitled to rely upon E&Y’s certification.”

Result? Plaintiffs allegations are upheld against 4 of the 5 individual defendants.

You can read In re NextCard, issued March 20, 2006, at 2006 U.S. Dist. LEXIS 16156.

Nugget: “While allegations that Defendants were involved in a “scheme” are relevant to paint a picture of what was going on at the company during the class period, and may be relevant to the question of scienter, the Court’s focus must be on the alleged misrepresentations and omissions made by Defendants.”

Lead Counsel Sued for Not Suing Andersen

Sheesh, talk about one giant pain in the you-know-what for Bernstein Litowitz and Kirby, McInerney & Squire. Do tell you say? O.K., so you remember the Bennett Funding Group securities class action, right? Well, don’t worry if you don’t, because it was filed back when Dolly the Sheep was born, and wrapped up around the time the last Pyrenean Ibex was found dead. So why do we care now you ask? Well, because in 2002 three law firms (Chikovsky and Shapiro, P.A., Shapiro & Shapiro, and DiJoseph & Portegello — good luck finding their websites) brought a lawsuit against the two firms, which were lead counsel in the Bennett case, because their clients were “upset over the law firms’ failure to name Arthur Andersen & Co” as a defendant in the case (of course, one naturally assumes they first thanked lead counsel for the $166.5 million in settlements achieved in the case).

But you know, it really seems like Judge John E. Sprizzo (S.D.N.Y.) is getting fed up with these malcontents (the Shapiro gang that is), as he issued an injunction that prohibits them from “sending further notices to Class members without prior Court approval,” and from “filing and/or proceeding with any legal malpractice claim against Class counsel relating to losses incurred in Bennett Funding securities in courts other than in this Court.” When a jurisdictional issue arose, Judge Sprizzo “ordered the parties to submit simultaneous briefs on the issue of jurisdiction by November 7, 2005.” What happened? According to Judge Sprizzo, not only did Plaintiffs “fail to offer a submission,” but their “local counsel, Arnold E. DiJoseph, III, refused to appear at this Conference, opting instead to send a wholly unprofessional and wildly accusatory letter directly to the Court of Appeals.” Smart thinking DiJoseph. Brilliant.

Anyway, after finding that SDNY does have jurisdiction, Judge Sprizzo threw the case out for good, commenting that “having declined to opt out of the class action, plaintiffs have reaped the benefits of the work done by the law firms and have either failed to object to the fees requested by the law firms or have failed to convince this Court that the fees were not warranted. Despite this, plaintiffs now seek to drag the law firms into court essentially to recover from the law firms for losses incurred in the Ponzi scheme that formed the basis for the underlying action. As Judge Sporkin so cogently noted in Thomas v. Albright, to unleash such suits upon class counsel in fora far and wide would severely undermine the class action system and would discourage able counsel from taking such cases to the detriment of those for whom a class action suit may be the only vehicle for achieving justice.”

You can read Achtman v. Bernstein, Litowitz, Berger & Grossmann, LLP and Kirby, McInerney & Squire, LLP, issued January 5, 2006, at 2005 U.S. Dist. LEXIS 38375.

Nugget: “Plaintiffs were free to opt out of the class action or simply to pursue their own claims against Andersen, as others did. Having chosen not to do so or even to object to the law firms’ counsel fees, they should not be permitted to attack the quality of the law firms’ representation on that ground in a separate action.

PWC Raises Too Many Flags

Judge Harold Baer, Jr. (S.D.N.Y.) has denied PwC’s (You simply must click this link – why in the world does PwC have this lady staring at us like this? Make her stop, we beg you!) motion to dismiss in the securities class action against Hibernia Foods “an Irish public company that exported beef until the ‘mad cow’ episode in 1997 when it switched to the sale of frozen desserts and ready-made meals.” Wow, talk about an overreaction, huh? Plaintiffs said “PwC knew or recklessly disregarded risk factors e.g., Hibernia’s repeated default on payments to lenders and suppliers and the sale of inventory at a loss to generate cash flow.” PwC balked, saying Plaintiffs were not “specific enough to show how and when PwC acquired knowledge of an alleged fraud.” Well, unfortunately for PwC, Judge Baer said “to plead with particularity does not require at this stage that Plaintiff spell out the very moment PwC should have known about the alleged fraud or that PwC had actual knowledge of the scope or particulars of the scheme.”

Judge Baer also recognized that “Plaintiffs allege that PwC wanted to keep Hibernia as a client so that PwC could continue to derive a financial benefit from its client.” Sounds reasonable, right? Perhaps a bit frustrated with those who might disagree, the judge offered the observation that “while not so far fetched to me, the current state of the case law holds otherwise and concludes that no independent auditor would risk ruination of its reputation for the fees it would collect in order to suppress fraud.”

But, as it turns out, the red flags were waving too high and too fast. The court found that “the ‘red flags’ include, inter alia, allegations that Hibernia (1) repeatedly defaulted on payments to lenders and suppliers, (2) sold its products at a loss, (3) recognized revenue on products that had not been shipped, and (4) failed to write off valueless inventory or write down long-lived assets.” Although “PwC argues that these ‘red flags’ offer only conclusory allegations that PwC should have known this behavior was tantamount to fraud,” “these facts, which must at this stage of the litigation be taken as true, illustrate at the very least behavior that could not conceivably escape a rational auditor’s critical eye, if his eyes were open.”

You can read Whalen v. Hibernia, issued 2005 U.S. Dist. LEXIS 15489.

Nugget: “When all the ‘flags’ are run up the same poll [surely it said “pole,” right?], it seems inescapable that a reasonable auditor was on notice, and acted recklessly when it disregarded all the ‘flags.’”

KPMG Tagged as "Virtual Pushover" in Xerox Decision.

Judge Alvin W. Thompson (D. Conn.) has denied all of the motions to dismiss in the Xerox securities class action, which brings ’34 Act claims against the company, six of its executives, and KPMG. According to Plaintiffs, Xerox “was able to meet Wall Street’s earning expectations only by engaging in massive accounting fraud.” In doing so, Defendants “used a smorgasbord of methods to misstate Xerox’s earnings, revenues and margins in virtually every reporting period throughout the Class Period.” Xerox’s “improper accounting methodologies throughout the Class Period included” what its auditor “KPMG referred to” as “half-baked revenue recognition,” and rampant abuse of “Cookie Jar Reserves,” just to name a couple. In fact, “without such accounting manipulations, Xerox would not have met earnings expectations in 11 of 12 quarters during 1997-1999 . . . Moreover, by 1998, almost $ 3 of every $ 10 of annual pre-tax reported earnings and up to 37 percent of Xerox’s reported quarterly pre-tax earnings were generated through undisclosed accounting manipulations.” Internally, Xerox “approved of and expressly directed the use of ‘accounting actions’” when referring to the accounting manipulations. In fact, a former Xerox Assistant Treasurer (who was fired when he attempted to expose the fraud), “stated that many executives at Xerox had developed the attitude ‘There is no accounting standard we can’t beat.’” How’s that for a marketing slogan?

Initially, Xerox tried to blame everything on its “Mexican subsidiary,” (sounds a little like the runaway bride, doesn’t it), but eventually that ruse was exposed. By the time the dust of two restatements settled (along with what was at the time the largest SEC fine in history), Xerox shareholders were stuck with “a total reduction in profits of nearly $ 2.4 billion for the years 1997 to 1999.” Ouch.

Given these facts, the court appears to have had little trouble denying each Defendant’s motion to dismiss. The court found that the factual allegations “make it clear that this is not a case of a client innocently relying on advice from its accountants,” as the “Xerox Defendants knew the company was underperforming and used accounting manipulations to bridge the gap between actual versus desired financial results,” the CFO “informed Xerox senior management, including both the chief executive officer and the chairman of the Board of Directors, that without the benefit of the accounting actions, Xerox had essentially no growth through the late 1990s, that the directives as to the accounting manipulations emanated from Xerox senior management,” “that many of the Xerox Defendants’ accounting manipulations involved violations of simple and unambiguous accounting principles, and in specified instances, the Xerox Defendants were told by their accountants that the accounting action violated GAAP but proceeded with the action anyway,” “that the Xerox Defendants insisted that KPMG replace its senior audit engagement partner when he refused to sign off on one of their proposals,” and “filed a minimal restatement and came out with a press release saying they had cleaned everything up, knowing full well that the staff of the SEC still had serious problems with Xerox’s accounting.”

As for the six executives’ knowledge, the court said “the plaintiffs do not allege scienter on the part of the Individual Defendants simply by virtue of the positions those individuals held at Xerox, but rather by virtue of the fact that Xerox’s senior management orchestrated the scheme to disguise the company’s true operating performance and the directives as to the accounting manipulations emanated from Xerox senior management at corporate headquarters.”

Finally, the court denied KPMG’s request to dismiss the case, as “the factual allegations in the Complaint do, in fact, portray KPMG as a virtual pushover in its dealings with the Xerox Defendants, which at a minimum went along with accounting practices it knew to be clear violations of GAAP, and which, even after it was clear early in 2001 that there were very serious concerns about Xerox’s accounting practices and it was apparent that it was questionable–at best–whether Xerox took seriously its obligation to comply with applicable accounting rules, was intimidated into signing off on a minimal restatement of Xerox’s financial statements that accounted for only a small portion of Xerox’s overstatements of revenues and pre-tax earnings.”

C’mon guys, don’t be so negative. Look at the bright side. At least there should be plenty of copiers available for all those documents those pesky owners (a/k/a shareholders) will soon be subpoenaing.

You can read the decision, issued July 13, 2005, at 2005 U.S. Dist. LEXIS 14427.

Nugget: “The PSLRA does not require a plaintiff to prove his case in his complaint. And, it is appropriate to recall that the heightened standard of pleading scienter was meant simply to prevent strike suits and other abuses that had arisen in securities fraud litigation. . . . Plaintiff generally must frame the facts respecting the defendant’s mental state (i.e., the scienter element of the claim) without the benefit of discovery, and therefore, most often, allegations about a defendant’s culpable state of mind must be drawn from limited state of mind evidence augmented by circumstantial facts and logical inferences.”

Deloitte Ordered to Hand Over Foreign Documents

After reading this one, you might not take blowing off providing a detailed privilege log so lightly next time. You see, in connection with the Parmalat securities litigation, Deloitte Touche Tohmatsu (“DTT”) (known since 2003 simply as the brand “Deloitte”) will be required to “produce documents located in Switzerland that were provided to it by member firms of the Deloitte organization, allegedly for the purpose of obtaining legal advice in connection with an investigation into the Parmalat scandal by the S.D.N.Y. U. S. Attorney.”

First, an understanding of how major international accounting firms are structured is helpful. Basically, “Deloitte and other such organizations consist of individual firms organized under the laws of each of the countries in which business is done, as well as an umbrella entity with which the individual, country-specific firms are affiliated. In Deloitte’s case, DTT is the umbrella organization, and it is organized as a verein under Swiss law, a form of business organization that DTT asserts is analogous to an incorporated membership association. According to DTT, it ‘does not control its member firms’ and performs no accounting or auditing services.”

Well, “when it became apparent that there would be litigation relating to Parmalat, DTT engaged a U.S. law firm to provide legal advice to DTT and on behalf of certain member firms that conducted the Parmalat Audits and which it coordinated. Some member firms provided DTT in Switzerland with documents concerning the Parmalat audits for review by that law firm. Others allowed the law firm to go to their offices in their respective home countries to review documents. To whatever extent DTT possesses or controls documents relating to the Parmalat audits, it asserts, it does so only by virtue of the foregoing. These documents would have been unobtainable by subpoena prior to their transfer to DTT, it contends, and they therefore should be unobtainable now by virtue of the attorney-client privilege.”

Unfortunately for Deloitte, this wasn’t good enough to keep Judge Lewis A. Kaplan (S.D.N.Y.) from telling it to fork the documents over. He began by posing the “threshold question” of “whether these documents would have been obtainable by subpoena in the hands of the DTT member firms.” To that he answered: “there simply is no way to tell on this record.”

Why? Well, first he noticed that “there is no privilege log.” Oops. Nor had DTT disclosed the “identities of the producing firms, the documents as to which DTT asserts privilege, nor the identities of the firms that also retained DTT’s U.S. law firm.” Double oops. Judge Kaplan held that “these are not irrelevant details,” noting that the rules require that any party objecting to disclosure on grounds of privilege produce a privilege log, and that DTT’s failure to provide one is by itself sufficient basis to overrule their objection.

Secondly, “and independent of the prior point, the vagueness and opacity of Deloitte’s presentation prevents anything other than an ill-informed guess as to whether the documents sent to Switzerland by member firms could have been obtained by compulsory process directly from the member firms. It may well be that some or, indeed, all of the producing firms are subject to U.S. compulsory process and perhaps even more likely that the materials could be obtained pursuant to the Hague Convention on Taking Evidence in Civil or Commercial Matters.”

Better fire up that Xerox. What’s the moral? You be the judge. But a good start would sure seem to be providing that privilege log, and perhaps easing up a bit on that perennial favorite two-step called the “overbroad and unduly burdensome” routine.

You can read the decision at 2005 U.S. Dist. LEXIS 12554.

Nugget: “Documents held by an attorney in the United States on behalf of a foreign client, absent privilege, are as susceptible to subpoena as those stored in a warehouse within the district court’s jurisdiction.”

Accounting Firms’ Foreign Subsidiaries in For the Long Haul

In the Parmalat securities litigation, Judge Lewis A. Kaplan (S.D.N.Y.) has ruled that the Italian subsidiaries of Deloitte and Grant Thornton will not be dismissed from the action, despite their argument that they “each are factually and legally separate from their Italian affiliates and therefore cannot be liable for the affiliates’ alleged fraud.” Although the court rejected Plaintiffs’ alter ego argument, it did find that “an agency relationship existed between [Deloitte, Grant Thornton,] and its member firms that conducted the Parmalat audit. As principals, they would be responsible for the actions of their agents and the knowledge and, consequently scienter, of their agents is imputed to them.”

In addressing the causation elements of Dura, Judge Kaplan found it “difficult to imagine that the markets would not have moved on the basis of reports by Parmalat’s independent auditors,” and therefore held that Plaintiffs “have pleaded transaction causation sufficiently.” As for loss causation, the court found Plaintiffs met that hurdle too, holding that “an allegation that a corrective disclosure caused the plaintiff’s loss may be sufficient to satisfy the loss causation requirement, [but] it is not, however, necessary.” The court went on to observe the fact “that the true extent the fraud was not revealed to the public until February – after Parmalat shares were worthless and after the close of the Class Period – is immaterial where, as here, the risk allegedly concealed by defendants materialized during that time and arguably caused the decline in shareholder and bondholder value.”

Last, but certainly not least, Judge Kaplan confessed he “is in substantial sympathy with defendants” with respect to their motion “to dismiss the complaint under Rules 8(a)(2) and (e)(1), [because] at 368 pages and 1,249 paragraphs, it is too long and confusing.” He remarked that “the requirement of pleading fraud with particularity does not justify a complaint longer than some of the greatest works of literature. A complaint of this length, indeed, is an undue imposition on all who are obliged to read it. Nevertheless, a dismissal under Rule 8 is usually reserved for those cases in which the complaint is so confused, ambiguous, vague, or otherwise unintelligible that its true substance, if any, is well disguised. Although plaintiffs’ submission is lengthy, it does not overwhelm the defendants’ ability to understand or to mount a defense, [and therefore] it will not be dismissed under Rule 8.”

You can read the decision, issued June 28, 2005, at 2005 U.S. Dist. LEXIS 12553.

Nugget: “The significance of the corporate form to the development of capital markets and economic progress in general cannot be denied. Nevertheless, the limited liability entity is not an unmitigated blessing. The limitation of liability that encourages capital formation in some circumstances may eliminate disincentives to fraudulent behavior.”

Nugget: “Independent auditors serve a crucial role in the functioning of world capital markets because they are reputational intermediaries. In certifying a company’s financial statements, their reputations for independence and probity signal the accuracy of the information disclosed by the company, the managers of which typically are unknown to most of the investing public.”

Nugget: “Certification by an entity named Deloitte & Touche, Grant Thornton, or one of the small handful of other major firms is incalculably more valuable than that of a less known firm because the auditor “is in effect pledging a reputational capital that it has built up over many years of performing similar services for numerous clients.”

Nugget: “In consequence, allowing those organizations to avoid liability for the misdeeds and omissions of their constituent parts arguably could diminish the organizations’ incentives to police their constituent entities, with adverse consequence for participants in capital markets.”