Dronsejko v. Grant Thornton, Nos. 09-4222 and 10-4074 (10th Cir. Jan. 20, 2011) is a securities class action against the auditors of iMergent. The complaint centered on an alleged improper revenue recognition scheme at the company between October 2002 and October 2005 which materially overstated revenue and resulted in a restatement of the financial statements. Specifically, the claims were based on the revenue recognition policy of the company. Under that policy revenue could be recognized on the sale of licenses based on Extended Payment Term Arrangements under certain circumstances. GAAP permits such recognition if there is persuasive evidence of an arrangement, the delivery of the product has occurred, the fee is fixed and determinable and collectability is probable. Here the company recognized 100% of the revenue from these arrangements despite the fact that it collected on average only 53% of the total purchase price. In its 2003 and 2004 10Ks the firm stated that 47% of its extended payment term sales were uncollectable. The SEC had told the company that the collection rate had to be substantially more than 50% to recognize the revenue. Plaintiffs claimed that the unqualified audit opinions of the defendant were false and misleading. The district court dismissed the case, concluding that plaintiffs had failed to adequately plead a strong inference of scienter. The circuit court affirmed.
Initially the circuit court noted that the third, fourth, sixth and ninth circuits had developed a recklessness standard specifically for Section 10(b) claims involving outside auditors. This standard is “especially stringent” and requires “a mental state so culpable that it approximates an actual intent to aid in the fraud being perpetrated by the audited company.” (internal quotes omitted). Here the court concluded that it need not consider this issue since under any standard the complaint is deficient. The issue raised here is based on a claim that although the audit firm knew the facts about the collection rate, that it was reckless in concluding that a 53% collection rate constituted “probable collectability” under the applicable principles which do not define those terms. While various sources use different definitions of “probable collectability” the court held that the failure of the audit firm to use those sources does not constitute recklessness. Likewise the magnitude of the restatement is of no import since it does not speak to the issue of recklessness. Indeed, it is well established that GAAP violations only support a claim of scienter when coupled with evidence of the defendant’s fraudulent intent to mislead investors. That is not the case here.